Sequoia Fund Q4 Letter: New Positions in a2Milk, Electronic Arts & Melrose

Ruane, Cunniff & Goldfarb is out with its Q4 letter for 2018.  Their Sequoia Fund finished the year -2.62% compared to -4.38% for the S&P 500.

New Positions in a2Milk, Electronic Arts & Melrose

During the quarter, the fund started 3 new positions.  Here's their thesis on a2Milk, a premium milk and baby formula producer in New Zealand:

"A good analogy here is Greek yogurt, which is believed in some quarters to confer health benefits you can’t get from regular yogurt. While Greek yogurt, like A2 milk, is a commodity product, companies like Fage and Chobani have built big businesses by wrapping compelling brands around it. a2Milk is attempting to do the same thing, to great effect thus far. Riding powerful consumer trends favoring products perceived to be healthy and natural, a2 has become the leading premium milk brand in Australia while making rapid inroads into the massive and quality-obsessed infant formula market in China. An effort to penetrate the U.S. milk market is also showing early promise."

Their new stake in Electronic Arts is a bet on gaming.  Games are taking more of people's time and are becoming more expensive to produce, favoring deep-pocketed companies like EA who have scale.  Sequoia feels the trends of digital game delivery and in-game purchases will benefit them.

Sequoia's bet on Melrose, on the other hand, is a bet on the jockey.  They write,

"Melrose is essentially a publicly-traded private equity firm, but with some very unusual twists. It mostly avoids borrowed money, focuses on only a small handful of investments at any given time and eschews dedicated funds that create a compulsion to invest without regard for the quality of the opportunities on offer. As with Berkshire and Constellation Software, the combination of a differentiated approach and a talented team has enabled Melrose to compile a hugely impressive long-term record of value creation. The company has never lost money on any of its realized investments, and in aggregate, it has produced an IRR of 24% per annum. At present, the company owns a collection of manufacturing businesses in the U.S. and Europe that span the aerospace, automotive and HVAC industries. In aggregate, they’re unlikely to grow any faster than the overall economy, but we think Melrose can make them substantially more profitable, and we ultimately expect management to sell them at attractive prices, freeing up time and capital for new opportunities."


Sold Almost All Of Their TJX Stake

During the fourth quarter they also sold almost all of their TJ Maxx (TJX) position.  This is notable as they first bought shares almost 20 years ago.  While the company is still operating well, they feel the future of the stock and business is less exciting as the PE ratio roughly double what they originally paid.

The letter also touches on 3 stocks that performed poorly for them last year that they still own: Mohawk (MHK), Naspers, and Charles Schwab (SCHW).

Embedded below is Sequoia Fund's Q4 letter:



You can download a .pdf copy here.

For more fund letters, be sure to check out excerpts from Baupost Group's Q4 letter as well as Oaktree Capital's Howard Marks latest letter.

Notes From Great Investors Best Ideas Conference (GIBI) Dallas 2017: Ackman, Einhorn & More

The 11th annual Great Investors Best Ideas (GIBI) Dallas Investment Symposium just took place where managers shared investment ideas to benefit The Michael J. Fox Foundation for Parkinson's Research and Vickery Meadow Youth Development Foundation.  Below are some brief notes on the event:


Notes From GIBI Dallas Conference 2017

David Einhorn, Greenlight Capital

Still owns a huge position in General Motors (GM) but has been trimming it since it's grown too large (risk management, position sizing, etc).  Still his largest position by a longshot though.  Still thinks it's very cheap and points to an opportunity for a new shareholder base to get into shares.  Likes they've gotten rid of its riskiest international business and is investing in autonomous cars and electric vehicles: the future.

He also likes Tempur Sealy (TPX).  Thinks estimates are way too low (notes that management's incentives are way higher).  The company had a dispute with Mattress Firm and stopped selling its mattresses there.  Despite that, customers still actively sought out the TempurPedic brand, so the co is replacing its lost Mattress Firm sales elsewhere at higher margins.  Thinks there's also a reasonable chance MF comes back to them since MF has lost sales.

Einhorn said that his 'bubble basket' of shorts in highflying tech stocks like Amazon and Tesla are valued like profits don't matter ... ever.  He says eventually people will wake up and profits will matter and their stocks will crater.  He also pointed to somewhat of a cult following status that is attached to Tesla's stock with all the hype that Elon Musk continuously builds with various projects.  There's around 30 stocks in Einhorn's bubble basket.   He noted he owns a Tesla, but also points out that the company probably lost $20-30k selling it.  Says company hasn't figured out how to make cars profitable on a unit basis.  You can also read Greenlight Capital's Q2 letter here.


Bill Ackman, Pershing Square Capital

Pitched his newest long: Automatic Data Processing (ADP).  Has an activist position.  Thinks it's a quality business: simple, not capital intensive, secular tailwinds (sees lots of growth ahead).  Automating employees.  Ackman thinks the stock's a double.  We've posted Ackman's presentation on ADP previously.

Also mentioned the GSEs he's involved with: Fannie Mae & Freddie Mac.  Still owns and thinks there's huge upside there.  He originally pitched these plays three years ago at the same conference.  Thinks they will eventually trade multiples higher of where they are now.

He's still short Herbalife (HLF) and has lost millions on the bet as the stocks' up around 40% from his average short price.  Said that of the risk factors considered for the position, Carl Icahn coming in and buying 20+% of the company wasn't one he considered.

Noted he still owns Howard Hughes (HHC) and while he doesn't see any immediate catalysts, thinks it's a long-term play as a high quality business.

Says average investor can be plenty concentrated with 10-15 holdings.  Biggest mistake of his career?  Not selling when new information emerged that didn't jive with his investment thesis.  You can read Pershing Square's Q2 letter here.



Tom Russo. Gardner Russo Gardner

Spoke about global brands and various companies still controlled by the founding families.  His best idea was the company hit with a scandal and PR crisis: Wells Fargo (WFC).  Previously he had noted how his WFC stake has remain unchanged (around 6% of his assets) and that he thought the company simply became too fixated singly on one variable (cross-selling) which lead to a bunch of accounts being opened in customers names.  The company now suffers from poor optics but on a risk level, direct financial harm has been modest and he has faith in the legal process.



Andrew Wellington, Lyrical Asset Management

A couple of picks:  Flex Ltd (FLEX), co is seeing double digit growth in its bottom line and 50% of FCF going to shareholders.  Trading around 12x earnings.

Affiliated Managers Group (AMG): asset management play, owns equity stakes in boutique management firms.  Says they own really good managers.  Trading around 12x NTM earnings.



Van Hoisington, Wasatch-Hoisington US Treasury Fund

He concluded that we're heading to a recession as the Fed has restrictive policies already in effect and money and credit are slowing noticeably.  Structural impediments to growth are over-indebtedness globally as well as adverse demographics.  Thinks rates will stay lower. 



Jeanie Wyatt, South Texas Money Management

A few ideas: Citigroup (C) as a value play.  Thinks it could re-rate from almost 1x book value to closer to 1.4x.  Since the crisis the company has a better situation and less subprime.

KAR Auction Services (KAR):  notes 20% EPS growth, end markets that are accelerating as well.  Trading just over 22x next year's earnings but with a big opportunity ahead as various leases will be coming to term.

Electronic Arts (EA): video game stock that's benefited from going over the top (OTT) as it leads to higher margins than the typical video game distribution model of physical games, etc.  Accelerating sales growth.  Also sees new potential upside in e-sports. 

Vodafone (VOD): Stock has traded sideways but the company has improved in end markets.  Thinks it offers good downside protection as sales growth has accelerated.


For more stock picks from recent investment conferences, we posted up notes from the Sohn San Francisco Conference yesterday.

Is Gamestop (GME) a Value Play or Value Trap? Quick Pitch

Market Folly has been adding a bunch of new features as of late. We started off with our stock of the week series and now we're going to begin a monthly 'quick pitch' on certain equities that hedge funds have been long or short.

Today's quick pitch focuses on Gamestop (GME): Value Play or Value Trap? The following is from Chris Lau, a SeekingAlpha contributor:

A major shake-up in the way games are distributed is unfolding. Activision (ATVI) and EA’s (EA) entrance in digital gaming is proving to be a winning strategy. EA’s online site, Origin, bypasses traditional sales channels. In the social networking space, Zynga’s (ZNGA) IPO showed investor willingness to take risks. Investors are putting money in the yet-to-be proven model of social networking games.

This leaves one major question: What does this mean for retailers like GameStop?


Hedge Fund Ownership (Or Lack Thereof)

The top holders of GME stock are largely vanilla mutual fund players like Vanguard and Fidelity. While Cliff Assness' quant firm AQR Capital owned a decently sized position as of 2011 year-end, there is practically no major hedge fund ownership in this stock (at least in the top 100 holders).


GameStop Backstory

GameStop has grown throughout the years, and especially after its acquisition of Electronic Boutique in 2005 for $1.44B. In the last few years as the digital downloading of games has proliferated, GameStop touted its knowledge of gaming and its consumers as a competitive advantage.

In recent months, investor pessimism has grown. Shares are 22.91% off from 52-week highs, closing recently at $21.70. The main concern lies in the rising shift to digital gaming from the traditional physical console games.

GameStop has tried to attack this shift head-on and saw over $450 million in digital sales last year. They've mainly offered access codes in stores that allow gamers to download content at home. GME was originally spun-off from Barnes in Noble (BKS) in 2002, yet another company battling digital distribution of content.

GME's management team has set aside money for further acquisitions in digital as they have cash and no debt.


Valuation

At $21.95 per share, GME trades at a P/E of 7.63 (using 2011 EPS of $2.87 that excludes write-downs). By comparison, Best Buy (BBY) traded recently at $22.95 with a P/E of 6.30 (using 2011 EPS of $3.64).


Why the Bulls Own the Stock

Bulls point to fears over digital distribution as being overblown and argue that the digital transition will take longer to play out and won't cripple GME. They feel as though GME has a dominant market position in the industry.

Joel Greenblatt of Gotham Capital runs a Compustat screen to create a 'Value 1000' index for value investors. GME is one of the main companies on that list due to its cheap valuation. Other bulls might point to a cap structure strategy and its cashflow story as compelling reasons to own it. The massive repurchases could potentially place a floor on the stock that can keep shares buoyant even if things take a turn for the worse. And given the high short interest, there's also potential for various short squeezes as these buybacks reduce the float size.

- During the last quarter, GME grew market share to record levels.
- Its expertise allowed the company to create new business models to fill profitability gap
- PowerUp Rewards program (launched October 2010) now has over 17 million members
- Pre-owned digital and mobile business will add $800 million in revenue in 2012
- The company is debt-free
- $500 million stock buyback
- Cheap valuation
- Continued partnerships with publishers to sell DLC


Why the Bears Are Short

Bears will argue that a secular shift to digital distribution of games and the rise of social gaming will lead to the demise of GME ala Blockbuster.

Hedge fund manager Jim Chanos of Kynikos Associates is a notable bear on GME shares as he argues that game publishers like EA are increasingly becoming direct competitors with GME. You can view his bearish presentation on GME here.

He argues that GME looks cheap and will appear cheap all the way down. Just like movies and music, Chanos says that the value of their brick and mortar presence will collapse. GME's counterpart in the UK, Game Group, recently filed for protection from creditors.

And while GME currently thrives on used game sales, that revenue stream could be in jeopardy in the future. It's been rumored that future iterations of Microsoft's Xbox and Sony's Playstation will likely have some sort of "anti-used games measures" built in to the consoles.

One risk that short sellers are cognizant of is that GME could potentially take themselves private or be taken over by private equity. Additionally, the cost to borrow is quite expensive due to the crowded short.

- Fewer packaged game titles are being released
- Short interest has climbed to 41%
- In its recent quarter, GME said physical console category declined faster than projected
- Comparable store sales dropped 3.6% in the last quarter
- 20% decline in hardware sales


Further Talking Points

During the company's recent quarterly conference call, management said that digital receipts are ahead of schedule. They have a goal of $1.5b receipts by 2014.

GameStop's recommerce (buy-sell-trade) for mobile devices, electronics, and tablets started in 2011. The company believes it can resell items like Apple iPads, assuming 5% trade-ins annually and a 12-18 month upgrade cycle. Sales would account for $200m by 2012 and $600m by 2014 which you can read about here.

GME forecasts growth that is reliant on physical games, hardware, and software. The short-term problem for the company is that a lack of new consoles in 2012 will pressure margins. GME's loyalty program must attract a higher proportion of digital sales.

Hot titles like Grand Theft Auto, FIFA Soccer, Call of Duty, and Max Payne 3 may be a catalyst for higher growth. These catalysts aren't necessarily reflected in the current share price and management kept only a conservative forecast for these releases.


Conclusion

GameStop (GME) is a company that dominates in its traditional space of selling physical video games, but it needs to grow-up in the digital world and faces challenges in adaptation. The negative price action in its stock as well as competitors (BBY), suggests that there is further downside. If console makers implement anti-used game measures, GME would have a tough uphill battle. Weak retail sales in electronics and heavy competition make this a stock to avoid at this time.


Thanks to Chris Lau for his contribution to Market Folly in our new 'Quick Pitch' series. If you have an investment write-up you'd like to submit, please click here to email us