Some comment on the Twitter buyout rumours

Twitter is wildly addictive. This is well known and there are people who check twitter more obsessively than anyone checked email.

Twitter is also a chaotic world full of trolls, useless information, porn-spam and videos of kittens.

It is also - as anyone cares to notice - for sale.

The gossip - and I have no reason to doubt this - is that there are on the Twitter board two factions:

• The CEO Jack Dorsey who wants to run the company and
• The board who - sick of pointless losses and running out of money - wants to sell it.

This leads to probably the most leaky sales process I can ever remember - with almost daily rumours about who is interested and who is not interested. The current rumour mill says all the "strategic buyers" are not interested.

In this blog post though I just run through the numbers and try to delineate what as a regular user (but an outsider) should be done. But I will cut to the chase now. This company should be and probably will be bought by an aggressive financial buyer. And Jack will be fired. (And - I think - the world will be a better place for that.)

Just the numbers 

You can find time series quarterly P&Ls (standardised by Thomson Reuters) here. An annual series is below.

Period End Date	31-Dec-2015	31-Dec-2014	31-Dec-2013
Revenue	2,218.0	1,403.0	664.9
Net Sales	2,218.0	1,403.0	664.9
Total Revenue	2,218.0	1,403.0	664.9
Cost of Revenue, Total	729.3	446.3	266.7
Cost of Revenue	729.3	446.3	266.7
Gross Profit	1,488.8	956.7	398.2
Selling/General/Admin. Expenses, Total	1,132.2	804.0	440.0
Selling/General/Administrative Expense	892.3	583.7	270.5
Labor & Related Expense	239.9	220.3	169.5
Research & Development	806.6	691.5	594.0
Total Operating Expense	2,668.1	1,941.9	1,300.7
Operating Income	(450.0)	(538.9)	(635.8)
Interest Expense, Net Non-Operating	(98.2)	--	--
Interest Expense - Non-Operating	(98.2)	--	--
Interest Income(Exp), Net Non-Operating	--	(34.0)	(6.9)
Interest Inc.(Exp.),Net-Non-Op., Total	(98.2)	(34.0)	(6.9)
Other, Net	14.9	(5.5)	(4.5)
Other Non-Operating Income (Expense)	14.9	(5.5)	(4.5)
Net Income Before Taxes	(533.3)	(578.4)	(647.1)

Here is what to notice. Revenue has gone up very nicely - from $664 million to $2.2 billion and is still increasing. And costs have gone up commensurately. Losses seem stubbornly stuck at half a billion per annum. That is real money - just burnt - and burnt by a business that is already established.

In other words costs have gone up by $1.5 billion give or take something. That is billion with a b.

Now if costs were rising that fast and the service were noticeably improving and engagemet growing then you could be tolerant. Making money is far less important in a growing tech company than increasing your relevance and the moat that surrounds your business. (Amazon is the leading example of a company which increases the moat every day.) The short-hand for that thinking is that revenue follows relevance.

But - as a pretty dedicated tweeter (with almost 20 thousand followers) - I have noticed almost no changes in twitter that improve my user experience. It is almost impossible to find out what they spend that $1.5 billion extra per annum on. I gather there are some improvements in the monetisation side but this is just a website - and it does roughly what it did in 2012 - and but spends well over a billion dollars more to do the same thing. [From my perspective the marginal improvement is that I am seeing fewer failed-to-load pages... but that is it.]

Twitter has become a parody of bad Silicon Valley management - the sort of management that existed in the dot-com boom where quite literally burning shareholder funds was considered a mark of innovation. 

The main difference between this and (say) Pets.Com is that underneath is a business that should be salvageable - and should make pot-loads of money. After all if they raised costs by $1.5 billion per annum without achieving jack-shit then costs should be able to be controlled. And if that is possible then Twitter as an LBO works on the back of an envelope at these prices.

Why a financial buyer not a "strategic buyer"

The news of the day is that almost all of the strategic buyers (other big tech companies) have pulled out of the bidding process. There is good reason why that should be the case.

If you run Salesforce.com for instance your main agenda should be on growing your business in a disciplined fashion. They are still in the stage of building relevance. And that requires friendly well directed management willing to let staff have their little well-directed flights of fancy (rewarding of course those fancies that grow the business). 

But Twitter is past that. Somewhere near half a billion dollars of costs need to be taken out almost immediately. And that involves firing people and being a general tough-bastard. It's inevitable anyway - because Jack Dorsey burning half a billion dollar per year isn't a sustainable business. The cash eventually runs out. 

The problem is if you mix this with a Salesforce.com or similar company it will be really hard to take costs out in a disciplined fashion without upsetting the culture of the home company. Instead this should be fixed (with extreme prejudice by a disinterested outsider) before it is sold again to a strategic buyer.

Or - in summary: the best bastards are from Wall Street. And this needs a Wall Street bastard. 

Carl Icahn - Twitter needs you. 

--

That said - there are things that need to be done that are not being done under the (seemingly incompetent and fashion obsessed) Jack Dorsey.

First troll detection has to be done much better.  There degree of incompetence in troll-hunting beggars belief. For example I have stereotypically attractive 20 year olds in bikinis who just want to do wicked things to me (and I am not even Donald Trump). I block them all and report them - but somehow Twitter has not managed to stop filling my time-line with porn spam. Blocking this is the sort of pattern recognition that computers should do - and if your spam-to-content ratio gets to high you eventually lose real users.

Also there is a lot of semi-commercial (even scam) spam here. Have a look at this twitter stream: https://twitter.com/doxitehydyla.

There are almost 10 thousand tweets - and they are all penny stock promotion mostly for the same penny stock. I think it is Russian but the location says Manchester. (Many scam promotion schemes look the same - and I do not think the penny stock promoters all live in Manchester.) The Tweets include a reference to some hot stock or controversial stock (Apple, Herbalife etc) and then links to a penny stock page. It is really obviously spam. But it has been around for months.

It also has 800 followers and not a single overlap with my followers. In other words almost all the other followers are spam bots too (because I seem to have overlap in followers with all serious financial tweeters). 

I could block five of these a day and there is still an endless supply. It makes searching for news about a stock almost pointless because the ratio of spam to real news is not good. 

I suspect the management incompetence goes further. If they actually fix the spam-bot problem then the truth about the active users numbers will out. It is weak (precisely for the reason above). But weak numbers mean they are all going to need to be fired. 

--

But lets play the numbers

Twitter revenue is still rising and is running about $2.5 billion per annum. It is a website that once ran extremely well on less than $250 million in costs. (No I am not joking.)

If you can't make this have a 40 percent operating margin then - frankly you are inadequately brutal. Personally I think 50 percent is possible.

At this market cap that works extremely well for a financial buyer. Its a no-brainer even.

So expect it to be bought. By some Wall Street bastard armed with a lot of debt. 

And that bastard will fire a lot of people. 

If I worked at Twitter I would be preparing my resume and providing a list of really quick things that can be done to improve the user experience - with the code all mapped out. That largely involves getting rid of spam bots and the like. But unless it radically improves the user experience or monetisation and you can convince the new owners you can implement then you are out. 

And the fashion-obsessed philosopher king. He is out too whether there is a buyer or not. That is necessary to save the company.

John 

PS. Long for the takeout which I see as inevitable. 

Some comments on the New York Times story about Donald Trump's tax returns

Decades ago - before I was a fund manager - I was the resident expert on tax avoidance working for the Australian Treasury. That was where I started to hone the accounting skills sometimes shown on this blog.

I very rarely do anything in tax - but now I think it is time.

The New York Times has published a story (including extracts) about Donald Trump's tax returns over two decades ago. The money-quote is this:

Donald J. Trump declared a $916 million loss on his 1995 income tax returns, a tax deduction so substantial it could have allowed him to legally avoid paying any federal income taxes for up to 18 years...

According to the New York Times the losses came

... through mismanagement of three Atlantic City casinos, his ill-fated foray into the airline business and his ill-timed purchase of the Plaza Hotel in Manhattan.

There is an issue here.

Donald Trump did not repay all the debt associated with those investments.

Either

• the loss is a real loss and the Donald was really was out of pocket by $916 million (in which case he has legitimate NOLs)
• or the loss was passed on to someone else by The Donald defaulting on debt - in which case Donald Trump should be assessed for income from debt forgiveness.

After all if the debt is forgiven it is not Donald Trump's loss. The loss is borne by the person who lent Donald money and did not get it back.

That - clearly stated by example - is why most income tax systems assess debt forgiveness as income.

--

Okay - I do not know whether Donald Trump had the wherewithal in 1995 to bear $916 million of losses personally. But I doubt it. (If he did his financial career is different from what is popularly accepted.)

So the alternative is the debt was forgiven in some way. But then the story the New York Times is running is wrong - because the $916 million of losses would not have survived the debt forgiveness and hence would have wiped out his NOLs and thus he would not be allowed to shelter his income for the next 18 years.

Unless that is there is an avoidance scheme the New York Times has not worked out. Those schemes go by the name of "debt parking".

Debt parking

Here is how debt parking works. Suppose the debtor (in this case The Donald) is going to get his debt cancelled for (say) 1c in the dollar. When he gets the debt wiped out the debtor (ie The Donald) will have to report assessable income equal to the debt wiped out (in this case 99 percent of $916 million).

The alternative though is for the debtor to set up a dummy party. The dummy party might be his wife or children or some company or trust set up by them or more likely some completely opaque offshore trust.

And that dummy party goes and buys the debt for say 1.1 cents in the dollar. Then they just sit there.

They don't force the debtor (ie The Donald) to repay. They don't make a profit or loss on the debt. And because the debtor never has his debt forgiven he never gets the assessment on debt forgiveness and he gets to keep his NOLs even though the losses did not come out of his pocket.

Every tax system worth its salt has some rules on "effective debt forgiveness" to prevent debt parking. And - from my experience which is now over twenty years old - none of them work entirely.

Now if Donald really has all those tax losses its pretty clear that the debt must be parked somewhere.

There is a vehicle out there (say an offshore trust or other undisclosed related party effectively controlled by Donald Trump) - which owns over $900 million in debt and is not bothering to collect it.

I do not have the time or energy to find that vehicle. But it is there. Now that this blog has gone public journalists are going to look for it.

There is a Pulitzer prize for whoever finds it. Just give me a nod at the acceptance ceremony.





John

Comments on investment philosophy - part one of hopefully a few...

This is the first of several investment think pieces I have in my head dealing with investment philosophy, where markets are now and maybe even a stock or two... They are surprisingly hard to write so these posts might come slowly...

---

When I was starting out in the investment game I read Warren Buffett's letters from inception, Ben Graham, Phil Fisher, anything I could on Charlie Munger and the rest of the standard investing canon. 

One thing that had a profound effect on me was Warren Buffett's twenty punch card. (Quoted here...)

Buffett has often said, "I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches - representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all. Under those rules, you'd really think carefully about what you did, and you'd be forced to load up on what you'd really thought about. So you'd do so much better."

Buffett is right. That would be a really good way to run your private investments - you would, I think, be very rich by the time you were old. And indeed Charlie Munger has run his career close to that way (though I suspect he is closer to 100 investments by now...) 

Charlie Munger has quoted Blaise Pascal approvingly: "all of humanity's problems stem from man's inability to sit quietly in a room alone."

There are plenty of people out there who call themselves Buffett acolytes - and as far as I can see they are all phoneys. Every last one of them. 

Find any investor who models themselves off Warren Buffett and look at what they do.

And look at their investments against a twenty punch card test. 

They fail. They don't even come close. Several big-name so-called Buffett acolytes have made more than three to five large investments in the last three years and at prices that can't possibly meet the twenty punch card test. Most phoney Buffett acolytes have been turning stock over faster than that.

Warren Buffett's two juniors (Todd Combs and Ted Weschler) have turned over many stocks in the past few years too - and at prices that don't reconcile with any twenty-punch-card philosophy. They are phoneys too. Just a little less egregious than many other so-called Buffett acolytes.  

I used to profess myself a Buffett acolyte too. But somewhere along the line I realised I was a phoney too. I just wasn't close to that selective and when the situation was right I wasn't anywhere near willing enough to pull the trigger and go really large in a position. 

There are psychological feedback mechanisms that stop you meeting the twenty punch-card test. Firstly it is really hard to be that patient. I did not find a new stock that met that test this year. Or last year. Or the year before. Or the year before that. I found one in 2012. And prior to that I had not found a new one since the crisis (when there were many available most of which I missed). 

But I am incapable of sitting idle since 2012 (even though the local beach is very good) and so I do stuff. Inferior stuff. Stuff that may produce inferior results. 

And some of it (thankfully not much) did produce inferior results. [I was long Sun Edison for example.]

And when you are wrong like that it is scarring. It makes you less willing to pull the trigger in quantity when something does meet the twenty punch-card test. Indeed perhaps the main advantage of the twenty punch card test is the avoidance of mistakes so you can (both psychologically and from a risk-management perspective) take much bigger positions when they come along.

Phoney Buffett-style value-investing is dangerous

A twenty punch card investment portfolio is - by its nature - a concentrated investment portfolio. If I had run my portfolio like that I would have come out of the crisis with maybe six stocks, turfed one or two by now and added a single stock in 2012. 

The rest of the time I would have spent reading, talking to management of companies I was never going to invest in, and otherwise tried to work out how the world actually works. (And the world is always more complicated than you imagine so the work is endless even if the activity is muted.) 

Many so-called Buffett acolytes (phoneys, all of them) have imbibed that a concentrated portfolio is a good idea. And so they present as having five to twelve stock portfolios and are prepared to take 30 percent positions. 

But the stocks often don't meet the twenty punch-card test. And so these investors wind up with large positions in second rate investments. When one goes wrong it is deeply painful. When three go wrong simultaneously it is devastating. 

The lesson here is easily stated: "if you are going to fill your portfolio with crap, it better be diversified crap". 

Several of my favourite phoney Buffett acolytes have been posting catastrophic losses. It was due. The phoney Buffett acolytes still here are just waiting for their turn to have catastrophic losses. 

Real twenty-punch-card investing is impossible to sell to clients

Just imagine if I had run a twenty-punch-card style portfolio and sold it to clients. We would have made a bunch of decision in 2008 and 2009 and our numbers would have been stunning to 2012. (Our returns on our longs were very good in those years. Way ahead of market.)

We would have turfed one or two of these. (Some businesses just change, others go up seven fold and are just not worth holding.) 

I would have bought a single big position in 2012.  

And since about mid-way through 2013 my cash holdings would be going up and up. Partly from dividends, partly from asset sales. 

And I would be underperforming now. Quite badly, even though returns would be positive. Come to think of it, my longs mostly are underperforming now. So are the longs of many fund managers I admire.

But mostly I would have been just idle. So in the midst of underperformance a client might ask me what I did last year and I would say something like

a) I read 57 books

b) I read about 200 sets of financial accounts

c) I talked to about 70 management teams and 

d) I visited Italy, the UK, Germany, France, Japan, the USA and Canada 

but most importantly I did not buy a single share and I sold down a few positions I had.

And I underperformed an index fund.

That is kind of hard to justify. I don't have a clue how you would ever sell it to clients. I can't imagine any clients buying it.

And so to my knowledge there is absolutely nobody who is true to the formula and who really runs a concentrated 20 punch-card formula fund. 

They are all phoneys because (a) the truth is so difficult it hurts and (b) the clients can't handle the truth.

What I did when I realised I was a phoney Buffett acolyte

Somewhere along the line I realised that did not have the temperament to be a true 20 punch-card investor. So I did two things.

a). Rather than accumulate cash and just sit there for very long time periods (five to ten years) I tried to find shorts. The shorts have two benefits (i) they turn into cash when the market goes down and twenty-punch-card opportunities arise and (ii) they attempt to make some money on their own.

b) I run a portfolio that is more divesified than I desire. I desire to be 15 stocks in 15 industries and seven countries, though in reality my desire should be to be more concentrated than that. [I would/should be happy with five 20 percent positions as long as they all meet the 20 punch-card test.] Alas (justified) lack of conviction means my portfolio is about 45 long positions - many of which are for sale when a better idea comes along. In other words when I hold crap at least I diversify it.

This is not entirely satisfactory. I get some longs wrong and lose money on those. And the shorts can be difficult to make money on even when you are right. A stock that goes from 10 to zero might look like a great short but if it goes via 50 then you are likely to be forced to cover some on the way up and its unlikely you will ever recover your losses.

We have strategies to manage both those problems and the results have been and will remain satisfactory although they will not always glow. There can be sustained periods of dull performance. And whist this is not as hard to sell to clients (or yourself) as a true 20 punch-card portfolio after a couple of years dull performance can become exhausting. Clients who haven't lost any real money will leave - because there is always someone else who is making money - and the grass is always greener - and because clients see performance more than inherent risk in any portfolio - and low risk portfolios can be dull.

Portfolio managers I admire

I still admire Buffett's portfolio management more than I can say. He really is astonishingly good at what I have chosen to do for a living.

But I can't emulate Buffett and nor can anyone else I know. And if someone uses his name to describe their investment philosophy my (likely accurate) presumption is that they are a phoney.

There are other managers I admire. I still think Kerr Neilson at Platinum is a freak but it is awful hard to emulate him though in at least part of my portfolio I try. I worked for him for seven years and have some idea how he does it. [He is unbelievably good at cyclical stocks for instance - something Buffett professes no desire to do and which I lack some of the skills necessary to do.]

But almost every other portfolio manager I admire is a long-short manager who has come to an investing compromise like mine. They aspire to be world-class long investors but irregularly fill their portfolio with more diversified second-class stock picks. And they run short books.

And the short books hopefully make money on their own - but mostly make money at the right times - delivering their profits in down years like 2008, and stripping them of profits in super-strong markets.

The problem is that almost every one of these managers is having a dull patch at the moment. These are people I think are amongst the best in the world. And I think (without naming names) that they are having the dull patch the same way as I am. In particular it is devastatingly hard to find things that meet the 20 punch card test. [If you have one please email me. I am prepared to listen to almost anything.]

So instead they have been buying things which are "ownable" rather than "buyable". In other words things that are sort-of-okay in that if you owned them for a decade you would probably be happy enough but not thrilled with the result. And the results from doing this have - at least over the past year - been dull. [Exception: if you bought pure bond sensitives as an alternative to bonds you did really well - but alas I did not do that...]

And the good long-short managers have found it easy to find egregious crap to short. Stuff where the story has more resemblance to fantasy than reality. The typical tell is massive differences between "the story" and the GAAP accounts". 

Some of these fantasy stocks have blown up (Valeant, Concordia) but many are alive and well and when I describe them as fantasy stocks I just get back hostility. And as a rule long "ownable", short "fantasy" has not worked that well. Truth be told it has produced results that somewhere between 5% positive and 5% negative. It has been hard work to go nowhere. 

And there are fund managers who are doing better. Some of them have tricks I do not understand (I put David Tepper in this camp - I simply don't get how he does it and hence can't emulate it*). But the ones I do understand I don't like. Their chance of a plus 20 is clearly better than mine. And their chance of a minus 40 is alas even better than that, and that is something I find abhorrent even if the clients are seduced.

Its really hard out there. I don't think it is a time to be greedy, but low to negative yields make it a difficult time to be safe/fearful as well. 

John

*The Tepper trade that most impressed me this cycle was long the airlines. I had enough knowledge to know this cycle would be good if I put the pieces together. But I did not put the pieces together and my allergy to capital intensive competitive businesses overwhelmed common sense. Tepper made a great trade that almost any Buffett acolyte would have ignored.

Fan blades - analysts adding value

I wrote a long post about fan blades the other day. In it I pointed out that fan blades on the front of turbofan jet engines (the ones on commercial jets) are really difficult to make. They spin fast (providing most the thrust for the plane). And they have to deal with bird strikes (which are surprisingly common). And finally they are not allowed to penetrate the engine casing if one were to fly off.

Fan blades have taken a surprising amount of material science to develop. They really are "cutting edge" stuff.

I talked a bit about Alcoa supplying the fan blades on the Pratt & Whitney geared turbofan (GTF) engine. Indeed I showed an Alcoa video of the project.





Well it turns out that these fan blades are the main reason for the GTF engine being slow to deliver.

The FT is running a story about how Pratt & Whitney are cutting engine production targets. It is not good news and they are blaming Alcoa.

Mr Hayes said front fan blades were among about five engine parts “that are causing us pain” by slowing deliveries. The company is continuing to build the engines, since fan blades go on at the end of assembly... 

The fan blade, developed with Alcoa, is made of aluminium-lithium alloy and tipped with titanium on the leading edge. Efforts to speed up blade manufacturing have taken longer than expected, leaving Pratt with fewer units than it expected by now, according to people familiar with the process. 

This year, we talked about delivering about 200 engines,” Mr Hayes told investors. “As I stand here today, I think that number is probably plus or minus 100 — more like 150 engines for the full year...

I encourage reading the article.

That said an analyst on the United Technologies conference call couldn't resist the chance to get in their question about 3D printing. 3D printing has uses - one is to make really complicated parts. But it is not much use in making really strong parts (like fan blades)* because there is in weaknesses where the product is added rather than made (say in a cast/forge process) as a whole piece from inception. 

Enjoy the question and the none-to-subtle put down:

Nigel Coe - Morgan Stanley - Analyst 

Obviously, GE is making a big play in additive manufacturing. Why couldn't you print out these fan blades -- what -- easy, right? It's simple. What is your play is additive? Is that a potential for Pratt? 

Greg Hayes - United Technologies Corp. - Chairman, CEO 

It's a potential for Pratt. It's probably a bigger potential maybe even with -- at the Aerospace Systems business. If you think about where additive really gives you the advantage, think about a fuel pump today, which is essentially a piece of aluminum or nickel that you hog out, you put all of these passages and cavities in, very, very difficult to machine. Where we see the opportunity there is through additive to be able to build these up 1/10,000 of a layer at a time, and build these cavities right in.

John

*I simplify a little here. Additive manufacturing (aka 3D printing) is of great use in making the moulds for casting. You can cheaply and easily print very complicated designs which you then use for making moulds. 3D printing has its place but nobody has yet come up with a way of actually printing the super-strong cast elements.

Saturday night pop anachronisms

Saturday night here in Australia - and music is on.

Can't help but notice the anachronism in some of the lyrics.

The Beatles Mr Postman is faintly ridiculous:

There must be some word today
From my girlfriend so far away
Please Mister postman look and see
If there's a letter, a letter for me
I been standing here waiting Mister postman
So patiently
For just a card or just a letter
Saying she's returning home to me

Still the BBC version is - well - fabulous...





But for sheer anachronistic silliness nobody can beat The Smith's classic double anachronism:

And now I know how Joan of Arc felt
Now I know how Joan of Arc felt
As the flames rose to her Roman nose
And her Walkman started to melt

Daddy what is a Walkman?







John

The end of Target's school charity program: demographic change or just bad management?

Addendum: I wrote this unaware of the fact that Target sold its credit card business a few years ago. That was insane too I think. But I gave up looking at Target about the same time I gave up looking at most retail. When I decided that I was perennially hopeless at analysing retail. The credit card story is however utterly real. Selling cards was just another piece of idiocy. The core work in this post was done in 2001... 15 years ago.


Target and Wal Mart once had very similar businesses - both discounters targeting similar demographics - both rolling across America.

When Wal Mart was in one town Target would just open in the next town. They were similar businesses but they did not compete.

Eventually America was saturated - you could not open a Wal Mart or a Target (or a K-Mart for that matter) without competing with an existing big-box discounter.

And then - and only then - did it become clear to anyone that cared to look that Wal Mart had lower operating costs and that to try and compete with them was a losers game.

--

K-Mart tried to compete with Wal Mart. It went to Chapter 11 (and will probably file bankruptcy again someday).

Target decided the way to co-exist with Wal Mart was to differentiate. So they did. They made the aisles wider and installed better lighting. That cost money but the stores were more pleasant.

Where Target held similar stock to Wal Mart they priced matched. But Target tried not to hold similar stock - it went up market.

The "target market" was middle-income but strained - classically a middle-income family with children, a wife who works less than she did and expenses that had gone up somewhat. They offered stuff for those people at a quality point above Wal Mart but still with a "discounter" ethos.

The average household income of a family that shopped at Target but not at Wal Mart was about 1.7 times the average household income of a family that shopped at Wal Mart but not at Target.

Target became "Targét" - a sort of aspirational up-market discounter.

--

I remember going to Target as a young professional about the time we had our first child. Children's stuff was displayed prominently and it was at a quality point that I was happy to buy. Target's shopping experience matched my demographic whereas I found (and still find) Wal Mart perplexing - extremely cheap but not particularly relevant to me.

--

I got interested in this because I was interested in Target's credit card.

The card was amazingly profitable - but to explain why I need to explain what makes a profitable credit card.

The average American has several credit cards in his or her wallet. There is one that is used every day at the "front of wallet". There is one at the back of the wallet used in an emergency.

The one at the front of wallet gets all the spend, a fair bit of rolling balance and is an essential part of the customer's life. It is usually very profitable.

The one at the back of the wallet doesn't get used much and is likely to be used if and only if the customer is financially stressed.

The one at the back of the wallet gets none of the daily revenue - but takes just as much credit risk. Statistically that card is likely a loser.

So credit card issuers want to get to the front of the wallet.

You also want the customer to roll a balance (ideally $2000-$5000) and to pay interest on that balance. Higher balances are often (not always) associated with genuinely financially stressed people and so may be less profitable (due to higher defaults).

Finally you want the people to feel really bad if they default. So you want people with a middle class aspiration and a deep fear of bankruptcy. In an ideal world it will be someone like a junior accountant with a young family. The junior accountant would be petrified of a record of bankruptcy - but they may meet the financially-stressed-with-young-kids demographic that Target was aiming for.

Credit cards have lots of tricks to move themselves to the "front of wallet" position. By far the most important trick is airline miles. Many an upper-income person shops preferentially on the card that gives them the best airline miles deal.

But for my financially stressed family airline miles are of only marginal benefits. Holidays are camping trips in the car (and Target will sell the family camping gear).

Whatever: Target needs another pitch to get to the front of the wallet.

And that pitch was a charity program. Target would give an education institution institution of your choice a donation equal to 1% of your spend. That institution was usually your children's school. [The old terms of the card can be found here.]

Combining credit cards with giving to your kid's school reduces the guilt of shopping on credit (or even rolling big balances). It moves the card to the front of wallet.

--

All very well - so Target now has accurately got to the desired position - the front-of-wallet position on a really nice demographic group.

But the card was profitable beyond even that. This card had more rolling money and lower default than any equivalent card I had ever seen. Obviously you want people to roll $4000 but the people who can't pay off their credit card are risky credits - so rolling balances and higher default rates are correlated.

But Target managed to achieve much better default rates than expected given their high rolling balances.

I puzzled over this for a while. I even asked some customers.

Strangely some customers believed something patently not true. At least some of them believed that if they defaulted on the card their children's school would find out.

The penny dropped. This was an absurdly profitable business. It gave money to charity (which is good) but it was brilliantly manipulative at the same time.

My respect for Target management (then very high) grew higher still.

This analysis was done in 2001 and my child was under 2 years old.

--

The occasion I had to think about Target's credit card was when Bill Ackman was trying to get Target to sell or spin out their credit card business. This was in 2009 and Mr Ackman was Target's biggest shareholder.

Target would not do it. They would not sell their credit card business.

Bill Ackman cried.

Actual tears.

And Target didn't explain why they wouldn't do what Bill said.

And I thought to myself of course they won't explain that. The whole program is too manipulative. But to sell it is to lose lots of value. This was a hugely good credit card business but it had to be associated with Target's demographic.

To explain the trick however would take some of the magic away.

So I kept my theory to myself.

--

And now I discover - much to my surprise - that Target has terminated their education charity program. Sure they gave a billion dollars.

And sure there are better charitable targets than the schools of middle-income kids.

But it struck me that Target is ruining or has ruined a very good thing.

The shift in Target's charity goals is to wellness related stuff (fairly loosely defined). Maybe that change is demographic.

But I suspect that it is just bad management. Maybe Target management imbibed some of that Ackman led Wall Street advice after all.

Thoughts anyone?






John

Albany International: a work program for a fund manager

This is going to be a stock note with a difference - because it is not a stock note. But it is about a stock/business - Albany International is a company that makes machine cloth based in upstate New York. The interesting part of Albany though is that it has a high-growth but unprofitable aerospace business.

The note however was an early work program to decide whether we wanted either

(a) no position,
(b) a small position,
(c) a large position.

The original note was a little rough - as it was an internal work program. And it involved a New York based investor who helped me with the leg-work in upstate New York. (As I do not have their permission I have not revealed either their names or the results of their work).

So I have tidied this note up a little and removed names since the original. But the note is accurate as to what we did and how we approached it.

If you wonder what a good fund manager really does this is a decent illustration. (I wish our work were always of this standard. It is a hard standard to maintain but I will try.)

For the record we settled on a small position. We were not entirely thrilled with the outcome of our research - but I am not going to tell you how we got to that conclusion. Rather I will leave the leg-work for you.

The work program was stated in a letter to my staff member (Luke) and my generalist New York friend.

Below is an edited version of that letter.

---

Fan Blades, machine clothing and Albany International

This is a project that I want to do as a joint project with James (name changed). So let’s start with an introduction –

James is a friend of mine from New York. He used to be senior at XXX (which is a way-more-than-average sophisticated fund manager). He probably has some pretty good New York connections and staff to help us do the checking there.

Luke is fairly new to funds management but has a PhD in physics – and has lots of experience as a high-end physicist/engineer – mostly in thin films. Luke is more than capable of checking any of the science that I am asserting. And I would like to be checked.

The target company is Albany International -

https://www.google.com/finance?cid=521

The market cap is just under $1.3 billion and they are based in upstate New York.

I was hoping James could do any New York style leg-work (scuttlebutt in upstate New York and finding out what we can about the Rochester plant described below) and Luke can check we are not bullshitting ourselves on the science.

The end margin of the aerospace business (described below) is also completely unknown. (I will guess – but it is a guess…)

Background 

Albany is a high-tech weaving company whose main business (where it is the world leader) is machine cloth. Machine cloth is the fabric that goes around paper plants and the paper is rolled between rollers and machine cloth.

Machine cloth naturally a pretty good business because better machine cloth makes better paper, plants get optimized making switching hard. Moreover machine cloth is a consumable and is not hugely vulnerable to the paper capital equipment cycle. There are a fair few competitors – most notably the paper making OEMs – but machine cloth seems to have sustainably high margins.

However the paper industry is in decline – especially the higher grades of paper which is where Albany has some position. So machine cloth is a good business in decline.

The company explicitly says that their job is run this business at as slow a decline as possible.

Albany International had lots of other businesses in the past – but they sold them all to focus on machine cloth and aerospace. They have purchased some aerospace businesses.

The original aerospace business comes from weaving carbon fibers. In the carbon fiber business there are a few dominant fiber providers (Toray in Japan, Hexcel in Stamford for aerospace carbon fiber) and there are a few resin companies (eg Hercules).

The carbon fiber fabrics are mostly made by formerly high-tech fabric makers. Indeed almost all carbon fiber weaving companies started at the technical end of fabric manufacture.

This is also the origin of Albany's aerospace business. The position Albany have in aerospace looks potentially good – but there is almost no revenue now (about $100m at a loss).

They are guiding towards $450 million in revenue in a few years.

If this revenue is at fat margin (likely but unknown) and the machine cloth business does not go away (also likely but unknown) then this should be a good stock.

Machine Cloth

First – I have verified externally absolutely nothing in this machine clothing business. (All my work has been on verification of the aerospace business). If anyone knows any way of verifying this stuff – for example has contacts in the paper industry – I would love verification. ("Trust but verify” is a good slogan.)

Here is Albany's web page detailing the business…

http://www.albint.com/business/mc/en-us/pmc/Pages/default.aspx

Company presentations give EBITDA margins in the high 20 percent range.

The presentations however focus on EBITDA. Alas anyone who knows about technical looms will know that it is a relentlessly capital intensive business (witness all the wining that Warren Buffett did in early Berkshire letters about the mess that the textile company was).

So lets pull the EBIT numbers rather than EBITDA –

But $140m in income on $655m of sales is not unattractive… its still greater than a 20% margin business. Alas this is before a disconcerting large amount of "corporate expenses and other". If all the corporate expenses are loaded on the machine cloth business (likely unfair) the margin winds up (pre-tax) at something like 10 percent. This is consistent with the GAAP accounts.

That said - I know little about the machine clothing business and verification would be nice.

The Aerospace business

The appeal of the stock however is the aerospace business and not the declining machine cloth business. The short-explanation can be found here…

LAMINATED COMPOSITES, USED IN EVERYTHING FROM THE skins of fighter planes to golf-club shafts, have one big flaw: They tend to come apart when the resin holding their layers together cracks under stress. Borrowing from the ancient art of braiding, Albany International Corp. in Albany, N.Y., has come up with a way to make laminated composites stronger. It's common to braid layers of a composite separately, but Albany International goes further by braiding each layer to adjoining ones. Anchored together, they can't slide past one another like cards in a deck--the leading cause of cracking in laminate resins. 

The company's Multilayer Interlock Braid technology is starting to find applications, according to the inventor, David S. Brookstein, who remains a consultant to Albany International after becoming dean of the School of Textiles & Materials Technology at Philadelphia College of Textiles & Science. The U.S. Army has used some of the prototype material to build inflatable arches for a portable hangar. And Brookstein says the company hopes to work with a large medical-device company to adapt the process to make a hip implant whose stiffness could be customized.

The only problem with this explanation is that it is from a 1995 story on Bloomberg. We are 21 years later…

Its kind of bold to assert this is a technology whose time has come…

The company has been making fairly bold claims though… this is also from a slide in (what was) the last presentation…

Note an “objective” of $450 million in revenue by 2020. (Is an “objective” lesser than an “expectation”?) And is the “assuming no new business” an indication that the revenue might be higher?

That said they have existing contracts including most importantly making fan blades for the LEAP engine.

LEAP is the successor engine to GE/SAFRAN’s engine for the narrow-body market (ie 737 and A320s). Note that GE current engines have a 65 percent share in that market but a lower share in the forward order book – so it is not as good as it looks. (The old one was the biggest selling and most profitable jet engine of all time…)

Here is the projection of LEAP revenue.

And there are a bunch of other programs that they think get them to 450 million run-rate by 2020.

They show pictures of their production facilities on the presentation – but most of these – as we shall see below – are JVs with SAFRAN. Here is the picture…

If these are real they must be JVs because there is (listed here) 1.2 million square feet of plant (and more under production) and there are only 1250 employees. This is a thousand square foot of plant per employee – which is – as you might observe – spaced out. So what these plants are and how much of them is owned by Albany International needs to be determined.

The margin question

I have no idea of the margin for all this aerospace product. That will be the determining question - because if this is fat margin business you want to own the stock. All I have done is some verification of revenue stream – particularly re fan-blades.

We will need to try and get a handle on what the margin will be. (More on this below.) However the way of thinking this is through the history of fan blades - and some discussion on how easy/difficult this project turns out to be.

Fan blades – a potted history

Modern commercial jets are “turbofans”. A turbine drives a fan at the front of the engine – and that fan creates up to 90 percent of the thrust. It also has to be able to withstand bird strike (at horrendous forces) and has to be enclosed by a case which is able to withstand an accident where a fan breaks off. (This is the so-called fan-blade-off test which is the hardest of the FAA mandated safety tests…)

The case and the fan are almost always a unit – and the tolerance between them is extremely fine. The inner surface of the case is usually some abradable material as the tolerances are so fine some abrasion is possible.

When Rolls Royce developed what was the first decent engine capable of carrying a wide-bodied plane (the RB211) they had an agenda of making an engine in which the fan could spin at a different rate to the core of the engine (which is done through multiple spindles) and having a carbon composite fan (made of a carbon fiber product called Hyfil).

They succeeded on the first task - Rolls Royce developed an engine in which parts spin at different rates.

But they failed comprehensively at a reasonable composite fan. The fan shattered when chickens were shot into it at high speed. (Obviously bird-strike is an area.)

So eventually they wound up with a titanium sandwich fan blade. You can see these blades and something of the manufacture in this video.




They key section goes from 12.20 to 17.40. (The rest of the documentary is kind of fun too…)

--

GE in JV with SAFRAN has managed to make a composite blade and they use it on their wide-bodied engines…

This is a video released by GE Aviation (apparently to the surprise of the Hexcel who told us that they had been told by GE that much of this is secret). Watch the whole thing – because you will get some idea of the tech.




Note that this is a laminate production process – the starting product is a roll of pre-impregnated carbon fiber. The supplier of that is Hexcel (based in Stamford) and the resin is supplied by Hercules. The Hexcel IR told us that the room is also refrigerated because the pre-preg goes off if warm.

Rolls Royce have always maintained that the Rolls Royce titanium blades are just as good as the GE blades. (GE of course differs and you can see their pitch here - http://www.youtube.com/watch?v=zy4A-z2WKhw.)

In fairness the claim to the most efficient long-haul engine has fluctuated between GE and Rolls with most the time Rolls having the current leader. This suggests that Rolls’ claim is okay.

One thing is indisputable. A composite fan requires gets paired with a composite fan-blade case. And that is lighter than a metal one. This is the main area in which GE engines are lighter than Rolls Royce ones. (There is an offsetting Rolls Royce advantage explained in this blog post… https://leehamnews.com/2014/07/10/is-the-a330neo-engine-rolls-royces-first-carbon-fan-model/)

For the most part - especially given the above blog post - I am mostly comfortable with Rolls Royce's claim that the titanium sandwich fan blade is competitive with carbon fiber blades.

Or I was comfortable before this: a video of a next-generation Rolls Royce engine (scheduled for a 2025 release…)





This is a film of a 747 flying with three standard engines and a "donor engine". The donor engine is very large and the fan blade is blue. It is blue because the blade is made of plastics.

When Luke and I went on a factory tour of Rolls Royce we asked them how they reconciled their previous statements that their titanium blades are as good as composite blades with the obvious research they were doing on composite blades.

Their answer: titanium blades are thinner than composite blades. This means that for similar aerodynamics they can be made less deep than composite blades – and this offsets the weight advantage of composite blades. This I have seen with my own eyes (sorry I do not have pictures) but the Rolls Royce blades are indeed less deep than the composite blades. This can sort of be seen in the above videos as well.

Then the clincher. The new technology will allow composite fan blades to be made as thin as titanium ones – and therefore (at least on engines larger than a corporate jet) the titanium ones will be obsolete.

It was this discussion that led us to Albany International.

Albany and LEAP engines

We know for sure that this is being used as the blade on the LEAP engine. Here is a video of the Rochester plant (see picture above)…



Note that it is a Safran plant but the signage shows it to be a JV with Albany. Moreover the video clearly shows carbon fiber being woven in an obviously complicated pattern. (Hexcel has confirmed to us that they provide the fibers to this plant.)

Moreover we have a press release from SAFRAN.

Moreover they have a similar JV plant in France.

And here is the French Prime Minister visiting a JV plant in France. There is a similar video a year ago with the French President.



This is obviously pretty important to Safran. Again it is quite clearly a joint venture with plenty of staff in Albany uniforms.

Questions we should think about answering

• What are the terms of the JV and how does Albany get paid? It seems in the press release to be an equal partnership but honestly I do not know.

C-FAN (the original composite fan blade business) is a JV between SAFRAN and GE. And only GE planes fly them. Is this a JV between Albany and SAFRAN because the JV wants to sell to parties other than GE (ie Rolls, Pratt & Whitney)?

• First question: Who provided the technology for the Rolls Royce composite blade (ie the blue one in the video above). 

We know a little about the Rolls fan from this press release – and it does not look like a braided/woven fan blade – which is somewhat contradictory of the argument above. In it Rolls says:

The new CTi blade is created by laying strips of carbon fibre, pre-impregnated with an epoxy resin, into a mould using a precision controlled robot. This is then cured in an autoclave by applying temperature and pressure (a bit like a very advanced pressure cooker). The moulded blade is precision machined and coated before a titanium sheath is bonded to the front edge. The finished component is inspected and measured using ultrasound and subjected to very rigorous mechanical testing

This looks a lot like the C-Fan video aboce – rather than the Albany-SAFRAN JV. Moreover the partner is GKN – the auto company that happens to make some carbon fiber components for the A350 – and that is not this sort of weaving. Those products are traditional carbon fiber laminates.

• Second question: What are the opportunities for Albany for aerospace projects beyond the ones listed. [I gather for instance that it is not possible to retrofit carbon fans to old engines because because the rest of the engine is essentially paired with a fan technology…]

• Third question: What are Pratt & Whitney doing re composite fan blades? I do not know but the forward order book of their geared turbofan product is pretty good. Getting the Pratt business would be nice. The GTF product probably has different forces on fan blades because the company has a gear box which slows the front fan blade down compared to the engine core.

• And finally the critical question: what eventual margin can I expect for all this business. My guess is about 30 percent – which seems about right for a new tech in aerospace – but in all honesty that is a straight guess. That would be enough margin to get excited about this stock.

If we can clear all this how do we value it?

I have deleted this section. It was a little crude - and you dear reader can do that yourself.


---

Now all this was a "work program" and we did plenty of work. And there are several things in this I know now to be wrong. For instance the geared turbofan has a metal fan as per this Alcoa video:





I suspect other suggestions in the work program are wrong. I am happy to be corrected. Email, phone. Please be in contact.





John Hempton

Meta-information and insider trading

This is a question that pops up from time to time. But I will do it by stylised example.

A small cap miner has announced a very significant gold find. The stock has moved from 10c per share to a dollar per share. 

The problem is that if the find really is as described it is obvious that stock is worth $5 per share. 

It doesn't trade at $5 per share because there is such a widespread history of small cap miners overstating (or even flat lying about) gold deposits. If you regularly bought the stock of small-cap miners announcing big finds you would probably go broke. 

Now imagine you are the drilling contractor who drilled the gold. So you know exactly where the drill samples were taken with certainty. 

And suppose you took those gold samples to the lab run by your brother without any third party intervention. And so between you you know with certainty that the drill samples are real and the gold in them was accurately measured. 

The results have been completely announced to the market. So the market has been fully informed. 

But you know one thing with certainty that other people don't know. You know the results have not been faked.

So you buy the stock and it is a five bagger. 

Note that every piece of information you have is public except one piece. The one piece is that the company is telling the truth.

Your information is meta-information. It is information about the quality of information.

So are you guilty of insider trading?

This is not an idle question. At the moment Herbalife (to pick a controversial example) is a cheap stock if the company is telling the truth. (And that is where my research has been focused.)

If you knew with certainty that the company was telling the truth you would buy the stock.

This situation comes up regularly with controversial stocks and is in background in almost all stocks I buy or short.

I spend a fair bit of my time trying to work out the quality of information given to me. A lot of the time spent stock-picking is spent on the search for meta-information. 

Discussion wanted both as to where legality begins and ends and (if anyone is game) on methods of assessing the quality of information.





John Hempton


PS. I am fascinated by edge-cases in insider trading. This one illustrates the difference between American and Australian law.

A gold explorer operating on their own privately owned tenement makes a big gold discovery. 

The discovery is alas right on the boundary of their tenement and it is open and spreads (pretty obviously) into the neighbours' tenement. 

The neighbours tenement is owned by a listed company (in this case a penny stock).  

They go and buy this penny stock aggressively whilst the majority holder of the penny stock sells aggressively thinking nothing is there.

Under Australian law this was found to be insider trading. Under American law I suspect it would be fine. The person owning the private tenement is clearly not an insider in the penny stock - but they do have material non-public information.

Okay - lets extend this. Suppose the drilling contractor works all this out too. And they join in the trading but the owner of the tenement (who hired the drilling contractor) has not freed the contractor to trade the (third party) penny stock. Is the drilling contractor okay under American law?

So which position will Mr Ackman exit: Herbalife or Valeant

Bill Ackman just exited his large position in Canadian Pacific.

This was a stunningly successful position: genuinely I wish I had done it.

It also produces a very large taxable gain.

Mr Ackman however has been producing less-than-stellar performance for his Pershing Square fund.

So at the moment he is leaving his clients with large losses plus a large tax bill. I can't imagine they would be thrilled with that.

Logically then Bill Ackman will wipe his taxable gain by reducing or exiting one of his large losing positions - either the short on Herbalife or the long on Valeant.

I really don't have any insight into which - but he is on the board of Valeant and that makes moving the Valeant position more problematic.

Thoughts anyone?




John

PS. This observation is not original. I received similar from at least three separate emails.

Herbalife and the end of the world

A necessary part of Herbalife being a pyramid scheme is that distributors are buying huge amounts of Herbalife that they cannot sell and are being encouraged to do so.

The term in the industry is "inventory loading". The FTC in their press releases mention inventory loading but do not specifically allege Herbalife is a pyramid scheme.

Inventory loading seems unlikely to me because Herbalife offers a 100 percent refund to distributors for unsold inventory including postage. (The length of time that refund is offered however is increased by the FTC settlement.)

I have looked hard for excess inventory (for example contacting sellers on EBAY or the like) and cannot find it. Truly I never found anyone who had $6000 worth of Herbalife sitting unsold, uneaten in their cellar.

Until now.

There are it seems a small class of customers who have signed as distributors and buy tens of thousands of dollars worth of Herbalife product precisely so they can store it in their cellars. They also shatter my preconception that personal use is limited to $200 or so worth per month.

They are millennial members of the Church of the Latter Day Saints who carry vast food stores in their cellars awaiting the end of the world. Herbalife shakes with a variety of flavours and long shelf lives are part of that store.

No I am not kidding. Sure it is an edge case - but the FTC settlement limits distributors to "reasonable personal use" volumes and members of the LDS millennial community are prone to buy quantities of Herbalife for personal storage far in excess of FTC/Company agreed volumes.

These people are real. And the Government is enforcing a deal which financially disadvantages them for their religious beliefs.

Truly.




John