Holiday links

This is going to be the last post of the year. This blog has certainly been fun to write and wanted to thank all of you who stopped by or reached out during the year, it’s been a pleasure. Posting will resume in the New Year. Meanwhile below is a bunch of links to keep you busy in the coming weeks.

Wishing everyone a (very PC) happy holidays and prosperous New Year.

Articles

A Dozen Things I’ve Learned From Bill Ackman about Value and Activist Investing (25iq)

Bill Gates’ list of best books in 2014

Bruce Greenwald on the Motley Fool, talking about value investing in Asia

Charles Brandes’ profile in the Globe and Mail

James Montier’s white paper on the world’s dumbest idea (shareholder value maximisation)

Another Montier link, this time on stock market valuation

Mark Mobius’ blogposts on Malaysia and oil

Mohnish Pabrai’s advice to a 12-year-old investor (Forbes)

Warren Buffett and the next 50 years (WSJ)

Brief history about Solomon Brothers (DealBook)

Interesting FT profile on chess master Magnus Carlsen

Very good post on the power of habits

Videos/Interviews

Amit Wadhwaney lecture

Arnold Van Den Berg’s annual client review

Aswath Damodaran’s CFA talk on valuations and story telling

Charlie Munger talk from 2008 held at CalTech

Mohnish Pabrai’s talk at Boston College

Jim Grant’s top 2015 ideas (hint: Russia)

Warren Buffett Q&A at the Forbes 400 philanthropy summit

On the shortness of attention span: Norway and the concept of slow TV (TED)

Rayonier Advanced Materials

Rayonier Advanced Materials (RYAM) is a supplier of specialty cellulose used in a myriad of products (cigarette filters, pharma, electronics, etc). The stock was recently spun-off from Rayonier, a timber REIT, which in my mind makes it a very interesting situation. With a REIT you get an investor base that’s dividend focused, however when you are given a share of what essentially is a commodities business (RYAM), which is going through a bit of a rough patch (near term overcapacity à lower prices à mgmt. guidance cuts) some investors are likely to dump the stock. Which is exactly what happened. RYAM started life around $40/share in June this year, reached high of almost $44 and now it’s bobbing around $22.

So what is RYAM exactly? The company buys woodchips and through it’s chemical processing produces what is called dissolving pulp (some call it natural plastic), which is then sold to buyers either in a speciality or commodity forms depending on grade. The company is the largest producer and has almost twice the capacity, as it’s next competitor. The key here is the specialty product, which is 2x of the price of the commodity version.

This market overall is around 1.6mt and RYAM controls 1/3 of the capacity and the top 3 control 70%. It’s two main competitors are Tembec (listed in Canada) and Buckeye (owned by Koch’s Georgia Pacific). While it is still a commodities business there are barriers to entry: (i) capital costs are substantial (RYAM spent around $2,000/t on a c. 0.2mt commodity to specialty production capacity conversion…imagine greenfield) and there has only really been one plant built – by Sateri (HK listed cellulose co) in Brazil - in the last 10+ years, (ii) customer relationships matter as constant supply of high specification product (e.g. for pharma) is needed and contracts are negotiated for 3-5 years. RYAM is currently around 80% specialty producer (after the capacity conversion), while it expects to be fully speciality by 2018.

Current market cap is around $1bn to which you have to add $0.9bn in net debt for total EV of $1.8bn. For this you get 2 manufacturing facilities in Georgia (0.52mt capacity) and Florida (0.155mt capacity), 85 years of experience, global distribution system operating in nearly 40 countries and 3 year average EBITDA of $360m (historical margins of 30%). In addition, the CEO of Rayonier decided to go with RYAM after the spin. Call it what you will, when mgmt. makes such a step I tend to look at it positively.

However, 2014 has been a tough year for the company and EBITDA is going to be around $100m lower year on year. The reason for that is a perfect confluence of negative events thus the outlook is pretty bleak in the near term (just look at downward consensus revisions on Bloomberg)

• Global production capacity of specialty dissolving pulp increased by 15-20% over the past two years with the majority from RYAM and other smaller players
• Before you shake your head in disbelief bear in mind that RYAM built it because their customers asked them to do so and this could be important for the long term
• This market grows 3-4% p.a., so will take about 4-5 years for this extra capacity to be digested (assuming no more new capacity or conversions of course, which is a big if), which results in limited pricing power for now
• RYAM noted that it plans to “feather in” this capacity, bring some capacity earlier to maintenance, move volume to commodity products to reduce the effective capacity in the specialty market
• However you also have to take into account the rationality of the other players, whom (e.g. Sateri) have been actually increasing volume at the cost of lower prices and to the detriment of RYAM

 

Source: Historical product prices. RYAM

So the outlook is pretty bleak and if I try to reverse engineer what the market implies I get to around $1,700/t price for the specialty product. I’m fixing the following: 90% utilisation rates, 80/20 specialty/commodity mix, $700/t commodity prices, 27.5% EBITDA margin and 7.5x multiple. This gets you to around $250m EBITDA.

I’m trying to estimate what this business could earn under various scenarios and how might the market price the stock then. The downside case assumes that the company will be selling more commodity products while the upside cases assumes that pricing will recover to a certain extent along with the margins:

• Downside: 70% specialty volume, $1,600/t specialty price, 25% EBITDA margin and 7.5x multiple – implies EBITDA of $200m
• Upside: 80%, $1,800/t, 32.5% and 8x – EBITDA around $310m
• Upside (II): 100%, $2,000/t, 35% and 8x – EBITDA around $425m

And the resulting share prices are: $14, $37 and $58 vs the current $22. If discipline returns to the market, along with pricing power, run rate EBITDA could revert back to $300m+ levels thus the market could be price the stock around $40 (roughly where it went public). Though I certainly think that you’ve to look through the next 12-24 months to get there.

In terms of risks, the company is highly levered (over 3x EBITDA) which it plans to take into the 2s, but happy to go up to 4x for strategic M&A (always be mindful of “strategic” and “M&A”). However, the obvious key risk is (assuming nothing goes wrong operationally) is that it’s a commodities business so it’s prone to cycles (both on the supply and demand side). For this I cannot come up with a mitigant apart from that you have to buy at “maximum pessimism” (as coined by the great John Templeton) or be prepared to stomach some volatility. You can ask the eager RYAM shareholders about this who bought in at $40.

Zicom Group and Orion Marine

A few weeks ago two companies crossed my desk that happen operate in similar segments thus taking a hint (from what obviously is a) divine signal I decided to look into them a bit more.

Zicom Group

The company is an industrial conglomerate (headquartered in Singapore), founded in 1978 and listed in Australia. Core segments (currently) are (i) offshore marine, oil and gas machinery (ii) construction equipment (iii) precision engineering and (iv) industrial and mobile hydraulics (if this doesn’t get you excited I don’t know what will). To note the businesses will be housed in two segments, likely by the next half, into (i) and (iii), which will also house new technology / engineering investments (more below). Zicom is 36% owned by Giok Lak Sim (chairman and group managing director) whose two children are also directors in the business.  To get this out of the way upfront the company is a microcap c. US$46m market cap and US$40m EV and in a good month about a US$1m worth of shares trade.

There are a couple of reasons why this could be an interesting situation.

Committed management. While Zicom is a controlled company, the CEO is remarkably forthcoming in his annual letters and other communication (most recent example here). He has been buying shares since 2008 in the open market and has also acquired shares instead of his cash bonus. In addition, his salary has been frozen since 2007. I could go on for a while but I find it positively surprising in the context of most Asian, controlled companies.

New business. Since 2010 the company has invested in what it calls disruptive technologies in the field of electronics and medical technology (VC type investments generally related to its precision engineering portfolio). The company invested over S$15m ($12m) equity in four businesses (Orion Systems Integration, Biobot Surgical, Curiox Biosystems and iPtec). While such investments can go either way the company is saying that most of these are on the cusp of commercialisation which you can essentially view as a free call option (i.e. not reflected in the valuation). As noted above the business will collapse into two segments, which will help reflect the performance of these new investments.

Valuation. The company is relatively cheap on a statistical basis and trades at 0.6x book (vs 0.8x historical), 5x EBITDA (vs 3-4x historical), 5x free cash flow (vs 9x historical) and 14x PE (vs 7x historical). The shares yield around 4% and the dividend is paid out of conduit foreign income, which is not subject to Australian withholding tax. In addition, the balance sheet is strong with S$22m cash and gross debt of S$15m.

Now what can go wrong. The core segment is offshore marine, oil and gas machinery (it makes winches for rigs and supply vessels) and while sales and orderbook have picked up since last year this is quite cyclical (with normally a 1-2 year lag), however management is positive on the outlook. But this should be considered: while offshore exploration picked up since the financial crisis so did Zicom's sales and orderbook (though remains cyclical) but given where oil price is currently and possibly where it is headed 2015 E&P capex is at risk as well as Zicom's business, which is perhaps not yet discounted (though you could argue that at 0.6x book it is). Base case thesis on the stock seems to be a late, cylical upturn in their O&G segment, however I’d be cautious.

In addition to the above the following could be negative as well: (i) VC investments flop (ii) bad corporate governance (so far no evidence) (iii) continued weakness in construction segment (has been weak as of late), which has exposure to the Australian market and (iv) technicality if you are running a large fund but the stock is quite illiquid.

Apart from a spike in 2011 the share price hasn’t moved materially over the last five years. Profit warnings have also preceded their last three earnings release so I’d say the market was quite pessimistic about the stock. This has been recognised by mgmt and as noted in the chairman’s letter they intend to do something about it so there appears to be a catalyst (let’s see their approach).

Depending on your stomach for volatility on the oil and gas front I think this is a very interesting business, with good and aligned management in place and potential upside from their new investments.

Orion Marine

Orion is a slightly different animal. It is approx. $300m market cap, civil marine construction company that is listed in the US and operates mostly in North America and the Caribbean. The company was founded in 1994 as a construction project management business and expanded into its current shape organically and via acquisitions (most recently a $9m purchase of an Alaskan company).

Orion provides marine construction services (to marine transportation facilities, pipelines, bridges etc), dredging (essentially maintaining waterways/shorelines by removing or adding soil) and other specialty services (demolition, surveying, underwater inspection etc).

In 2013 the company generated sales of $355m (mostly by bidding for various contracts) of which 60% was from the private sector and 40% from various government entities (federal, state and local). Key markets/customers are: ports, marine infrastructure, oil and gas, defence/homeland security etc. As it’s a contracting company backlog is key, which as of end 2013 was $247m ($242m as of Q3’14).

As you’d have guessed it by now Orion’s performance is tied to the general economic cycle but with a lag (just like Zicom so the business is very cyclical). For instance, in 2009 revenues reached $293m with gross and EBITDA margins of 21% and 17% respectively. By 2011/12 the margins were down to 4%/1% and 5%/3%. 2013 seems to have marked a turning point as margins have improved to 9%/6% and on TTM basis 10%/8%. Historically, average margins are 14%/11% (gross and EBITDA, respectively) so the company is trending towards those levels. Key drivers for the decline was drop in demand and also pricing pressure on contracts. So as you can see the business is choppy.

I’ve been looking at this stock many ways but the key story seems to be the recovery in marine infrastructure construction in the US. Just to highlight a few potential avenues for capex growth in this segment: (i) private sector: energy sector growing, expanding and refurbishing waterside infrastructure (e.g. gas related projects – ammonia, LNG, chemicals etc) not just in ports but inland waterways as well (ii) local port authorities growing capex (port deepening etc) for increased cargo volume and larger vessels primarily due to the Panama canal expansion and (iii) government funded programmes to improve, maintain and restore the coast (think damages of recent hurricanes or that accident in the GoM in 2010).

I’d say barriers to entry are medium. You need specialised equipment and trained people (nothing one cannot replicate given the resources) but gaining access to government funded projects (especially on the defense side) require all sorts of clearing thus these relationships are very valuable. On the other hand given that around 40% of revenues are from the government when funding hits a dry spell it can get pretty painful.

Due to the cyclicality it’s hard to value this stock and figure out what are the recurring numbers but an EV/Sales approach could give an indication of what the market implies. If you look since 2008 the peak has been 1.4x (2009; it’s actually been higher but only for short periods so 1.3x-1.4x more reasonable), which dropped to 0.4x (2012; again 0.4x only for short periods and 0.5x is probably a better indicator). It’s currently trading around 0.7x. So those are the ranges.

In 2013 the company generated $355m in sales and this year they are on track to do $385m (mgmt noted Q4 should be on par with Q3). Using 2014 sales and most recent net debt as a base at 1.3x it’s an $18/share stock and at 0.5x it’s worth around $7. Given where we are in the cycle I think 1x eventually is not ridiculous (i.e. lights at the end of the tunnel but not fully out yet), which would imply around $14 (vs current $11).

Commodity prices drive oil and gas capex and while Orion remains bullish on the outlook of private sector projects in the near term I’d tread carefully here (at least in the very near term). As a result of the cyclicality using say the average revenue since 2008 is perhaps more defensive. The same multiples on those numbers imply a range of $6 to $15, and $12 using a 1x multiple (i.e. fully valued) though it could get interesting in the $8-9 range. I think on the long-term horizon this is a very interesting story to watch.

To note Arnold van den Berg, the founder of Century Management, whom I admire greatly, is a large shareholder in the company (around 9% stake) and his thesis is very similar (i.e. marine infrastructure boom in the US of which Orion would be a beneficiary). In a recent interview with Graham and Doddsville he noted that he’d be a buyer should the stock dip to around the $9 levels.

Weekend links

CEOs contending with activists (WSJ)

Bill Ackman's Pershing Square Holdings Q3 letter

The bruiser and the billionaire (WSJ)

The man who taught Warren Buffett how to manage a company (qz)

A bearish hedge fund bets against the bulls and still profits (Dealbook)

Difference between an investment firm and a marketing firm (Jason Zweig)

Very interesting post on Shenzhen on BeyondProxy and an interview with the author of the post (his blog is worth checking out)

If you are a fan of Sherlock, Benedict Cumberbatch was interviewed by Charlie Rose recently

Vice recently did a profile titled "Real Wolf of Wall Street?" about a NY based investment banker

Weekend Links

Recent Hugh Hendry interview (part 1, part 2 and part 3). If you don't know him he is a London based macro manager and I really like his interviews/letters. There is a lot more videos of him on Youtube and here is his greatest hits (not one to mince his words)

Another talk from Guy Spier on his recent book. This one is at Boston College and runs two hours so there is a lot of great content covered

Great collection of articles/presentations from csinvesting on valuing growth

Bruce Greenwald talk on: Value Investing and the Mis-measure of MPT

Joel Greenblatt interviewed on Wealthtrack

Recently came across this great collection of talks from the London School of Economics' public lectures on various political/economic issues. You can access previous talks on their website which is great to browse through

Weekend links

On Buffett (he has been a busy bee this week)
Bloomberg article on the BNSF transaction
Buffett's private analysis of Geico (WSJ)
Two articles on the recent Duracell deal here and here

Q&A with Guy Spier on his book (MarketFolly)

I've been re-discovering Jason Zweig's articles. One on happiness, internet stocks and behaviour

Mark Mobius' blog post on Indonesia

Share buybacks done right (Cook and Bynum)

Keck Seng

Keck Seng is a real estate investor and developer with properties located in the US, Macau, Vietnam, Japan, Singapore, Canada and China. The origins of the company trace back to an entrepreneur by the name of Ho Yeow Koon, who founded the company in Singapore in the 1940s. The business is now controlled by his sons who took over ownership/management after his passing. To be clear there are two listed Keck Sengs - one in HK and one in KL - and the one discussed here is the HK listed co (HK:184). There is a connection between the two companies to the extent that the sons control and manage both businesses and the two companies invested jointly in two hotels in Canada, while new property investments are made by the HK company. The KL listed entity also owns plantations and other real estate investments.

The below is roughly how the valuation looks and as it’s a holding company I’m going for SOTP. There is a substantial discount to equity value, which might not surprise you much as it’s a SE Asian family controlled, holding company that invests in real estate (some trade at 40%+ discount, even the larger ones) but in the case of Keck Seng I think this is unwarranted, while the financials have actually been quite healthy historically as well. The company compounded book value around 10% over the last decade, free cash flow at 11% while pre-tax ROIC (ex cash) averaged in the mid teens.

United States – 47% of GAV

W San Francisco

• Acquired in 2009 in the middle of the property downturn from Starwood, which was going through a deleveraging process
• Paid $90m for a 404 room hotel ($222k/key) and a remarkable 15.1% cap rate ($13.6m NOI in 2008)
• As a comparison, in the first full consolidated year net profit after tax was HK$17m ($2m), while mostly recently in 2013 it reached HK$43m (c. $5.6m)
• Valuation: I’m using the average of (i) recent SF hotel transactions per key (avg of $350k/key) and (ii) cap rate of 8.5% (taking some discount to recent transactions) on 2013 free cash flow

Sofitel New York

• The company recently closed the acquisition of the Sofitel New York (midtown Manhattan) for $265m or 5% cap rate based on 2013 NOI of $13.5m. The hotel has 398 rooms ($666k/key)
• Before you jump to the conclusion that the 5% cap rate is high and some foreign investors paid crazy prices for a trophy asset consider that (i) asset is in prime location (ii) while not a bargain like the SF W, this rate is in line with recent Manhattan hotel transactions (iii) they’ll get recurring cash flow (iv) 70% cash financed so no real impact on leverage/balance sheet and (v) instead of repatriating cash from the W (and paying taxes…) they could use it to buy property in the US
• As a fun fact the transaction equalled their market cap at the time (which happened to equal the cash pile on the balance sheet)
• Valuation: transaction price

Macau – 34% of GAV

This is where the juicy stuff is in my opinion. The company has been involved with Macau for decades, mostly in residential and have been behind projects such as Ocean Gardens in Taipa, near the new casino developments on the Cotai Strip.

The interesting part here is that HK accounting allows the company to a hold a large chunk of their Macau assets at cost, which given the increase in property prices is nowhere near reality. You can find more details on Macau property price statistics here. KS’ property sales in Macau have slowed down since 2012 (none in H1 2014) as mgmt. is waiting for the completion of the bridge connecting Macau with HK (expected in 2016), public transport in Macau in 2015 and new casino developments.

As I noted in my post on RexLot I’ve no illusions about the Chinese government not going after excessive gambling and spending (this is a fact), however as (i) Macau has limited land supply similar to HK (ii) other trades develop such as conventions, family etc and (iii) healthy interest from mainland Chinese (though not the super rich but more geared towards well-off middle class visitors) property should continue to do well over the long term. There’ll be bumps for sure but KS will likely be less impacted as the majority of Macau assets are carried on their book at cost and any sale should be substantially profitable and result in better reflection of true value.

Properties held for sale

• Three buckets of properties with gross area of 412,500 sq. ft., which I’m valuing at 3 year average historical transaction prices
• Ocean Industrial (industrial property) with 22,900 sq. ft. at HK$2,600/sq. ft.
• Ocean Gardens (60 residential units) 163,000 sq. ft. at HK$5,000/sq. ft.
• Lot W (2x tower blocks of 40 residential units) 113,000 sq. ft. each at HK$6,200/sq. ft. (this is at a premium given that these are whole tower blocks with full serviced apartments and would command a higher price in a transaction)
• Valuation: pro-rata value of the above c. HK$1.6bn. To note these assets are carried on KS’ books at HK$280m

Properties held for investment

• Three properties consisting of two offices (Luso Bank and Ocean Tower) and one commercial building (Ocean Plaza)
• Valuation: pro-rata value of around HK$670m (based on recent transactions), which is not too far from the company’s reported figure of HK$703m in their H1’14 financials

Vietnam – 12% of GAV

• Two properties in Ho Chi Minh City (i) 64% stake in Sheraton (485 room hotel, including a casino, which is quite rare for Vietnam) and 25% stake in the Caravelle hotel, which was opened in 1959
• Now Vietnam had/has it’s own peculiar situation with state involvement and bad debt in the system (Moody’s estimates NPLs are around 10-15% of total stock vs 5% official figures) that has been fuelling a property bubble, in addition to increase in supply of hotel rooms, which pushed prices down
• Even under these circumstances the Sheraton continued to perform well and based on this experience it should continue to do OK, as well as with the government potentially opening up gambling to locals
• Valuation: I’ve the least confidence in valuing these assets so I’m taking a large discount vs numbers I came across from other sources. I’m using a 17% cap rate to value the Sheraton and 8x P/E on the Caravelle, which gets to around HK$830m

One thing to note about the Vietnamese operations is that up until now KS faced a US$55m (HK$420m) lawsuit, which was brought by one gambler whom, following an error in a slot machine, supposedly won $55m. Initially in 2013 the judge voted in his favour, however following some “mysterious” events this was withdrawn at the beginning of the year and thus the overhang from the stock is removed.

Other (Japan, Singapore, Canada and China) – 6% of GAV

• The other bucket includes (i) Best Western hotel in Osaka (ii) 5 residential units in Singapore’s Ocean Park (iii) two hotels in Canada and (iv) Holiday Inn Wuhan
• Valuation: around HK$410m; mix of book and recent market transactions

Valuation

Based on what I deem to be relatively conservative assumptions the gross asset value of the portfolio is HK$6.7bn and taking into account net debt of HK$680m (PF for the Sofitel transaction) and 20% holding discount/tax (based on weighted avg of the countries’ capital gains tax where KS operates; and a discount/tax should be applied to holding companies anyway) I get to c. HK$4.8bn (HK$14 per share) equity value vs market cap of HK$2.4bn (HK$7.1 per share) or an almost 100% upside. Kick in a 10% free cash flow yield, further growth in cash generation and a 2-3% dividend yield and it looks like an interesting story. As Macau sales resume, it should shed light on the true valuation of the properties and help the market value reflect intrinsic value better.

Looking at downside scenarios, if you assume that real estate valuations/prices in Macau go back to 2009/2010 levels, total portfolio equity value drops to HK$3.6bn (48% upside) and if you further assume that the valuation of Vietnam goes to 0 your upside is reduced to 22%. Assuming the portfolio is only worth what it’s carried on the books (HK$3.2bn; ex minorities) you’d still be picking up the company at 0.7x book. Should the stock trade down to it’s historical valuation of 0.5x book you’d get to a share price of HK$5, or HK$2 downside vs upside of HK$7 per share to my estimate.

Risks

With any controlled companies you can get mistreated by shareholders (money channelling out of the company, buying out substantially undervalued assets, stupid acquisitions, crony investments etc). While I’ve no better insight than you do, looking at past actions they seemed to have made rational capital allocation decisions and I think the shares are priced attractively from risk/reward perspective. Should things start to go bad corporate governance wise the stock is listed in HK with relatively strong minority shareholder protection in the region. Mind you the shares are quite illiquid so position sizing is key.

For further research, please see an article from Barron's on Keck Seng from this week.

Gaiam

I’m a yoga fan and have been practicing for years so the following idea is especially interesting to me. Don't worry I’m not here to convert you to any shaman/guru stuff, ask you to read this post in a lotus position or to extol the virtues of sustainable living but there is money to be made in the yoga, conscious and sustainable living/lifestyle trend that seemingly has no end in sight.

Gaiam is a Colorado based company that makes products for yoga, fitness and general sustainable living. The company was started in 1988 by a very interesting guy by the name of Jirka Rysavy. I’ve previously linked a few articles about him (here, here and here – do read them if you haven’t yet). To cut a very long story short (and the following by no means gives credit to his remarkable accomplishment) he emigrated from what then was Czechoslovakia to Colorado and cut his teeth in business. He started the predecessor of Corporate Express by rolling up small competitors in the office supply business. He figured that the trick to beat the other guys like Staples is to go wholesale (i.e. no superstores), target mid to large scale businesses as customers and keep the number of SKUs low and cheap by ordering in very large quantities, essentially scale in a business where margins are tiny. This worked so well that by 1999 revenues grew to around $4bn and the business was bought by a Dutch competitor for $2.3bn (EV basis). More details on the company and story here.

Back to Gaiam. Up until a few years ago the company was an eclectic collection of businesses. The core theme has always circled around sustainable living but the expression of this idea has certainly evolved. To give you a sense, it used to be a large shareholder in Real Goods Solar (US based solar energy company; now c. $1m stake remaining), owned Vivendi Entertainment (GVE; video distribution; sold in Q4’13), besides developing their core business yoga, fitness and other products. In the meantime they’ve also started a Netflix style subscription video service (Gaiam TV) with content around sustainable living (yoga and sports videos, movies, series etc).

The current core businesses are branded goods (clothing, home, sports and other apparel products) and Gaiam TV, which will be split into two companies as announced earlier in April 2014. Currently the fully diluted market cap is $187m with sales of $156m last year. Let’s see what you get for this price.

Branded Lifestyle Goods

In 2013 the segment generated around $150m sales by selling yoga and other fitness products via retail (around 38k locations globally inc. Target, Whole Foods or John Lewis in the UK) and through e-commerce/catalogue. The company uses it’s direct to consumer channel to test and refine products, which they can launch across their retail channel, which is a great advantage to have. Within the retail stores Gaiam operates 15k store-in-store facilities as well.

The key story here is the growth in the adoption of yoga and thus increase in sales of related products. There are various numbers out there in terms of market size but according to the company overall market was $10bn in 2012 vs $5.7bn in 2008 (CAGR of 15%, while the number of practitioners grew 7% p.a. in the same period).

However, with growth you get competition and thus brands are piling in to the market. Lululemon is of course the most well-known brand and with the highest mind-share but companies like Nike, Under Armour etc are making an entry. There is no clear leader in the mid-market segment which is what Gaiam is going after and given their positioning as one of the original yoga brands, great and expanding distribution network they have a good shot at succeeding or at least be in the top 3.

Gaiam TV

Gaiam took all of its yoga, fitness and related video content and built an online subscription network around it (you can think of it as the yoga Netflix). The titles can be streamed via their website and most devices (Apple TV, Amazon Fire, mobile platforms etc). Currently the company has over 6,000 titles, charges $9.95/month and had subscribers of about 46k last year (about 80k currently).

A few interesting stats about the business: (i) current conversion rate from trial to paying subscriber is over 75%, which is huge and (ii) producing an hour of content is about $4k on average (vs $4m for Netflix; yes I know it’s not a fair comparison: all you need is a few mats and some yoga pants vs paying Kevin Spacey to play a scheming politician). To add to the first point I’ve asked many people who either practice or teach yoga and they are huge fans of Gaiam TV and practically couldn’t stop raving about it.

The business generated about $5.6m in revenues last year and mgmt. guides for doubling this year. On a recent earnings call they noted that the company is runrating $10m in revenues. Now this business is still lossmaking (EBIT loss of $8.3m in 2013; about $2-2.5m burn per quarter) as money is being plowed back into growth, however mgmt. also indicated that if they’ve stopped spending on growth they could get this business profitable by Q2’14.

And this is key. The company announced that they are splitting the business into two due to the usual story for splits (growth, mgmt. focus, capital allocation etc) so Gaiam TV will be out in the open and people will be able to look at the businesses and financials better.

Which brings me to valuation, for which I think sum of the parts is the best approach. The current market cap is $187m, however the company has a lot of non-operating assets: $27m cash/investments (after adjusting for op. cash needs); $28m (tax impacted) net operating losses; $6m working capital adjustment from the GVE asset sale and about $20m value for HQs that they own outright, on which mgmt. is “exploring options”. If you net these off, you get to a value of around $106m for the operating business. The company generated sales of $156m last year so it trades at an implied 0.7x sales.

Next year they are on track to do around $160m in revenues (it doesn’t look like much improvement as the company changed in how they account for revenues for externally sourced products in their branded goods segment, now it’s on a distribution basis vs buy and resell; great news for working capital). Assuming Gaiam TV doubles sales to $11m and you slap a 3x multiple on it (where Netflix traded through the cycle; similar multiple to a recent Gaiam TV roll up acquisition), you get to $34m, which essentially means that the branded business that generates $150m in sales is valued at only $72m or 0.5x sales. This is basically what’s implied by the market.

This is how I think of fair value: $20-30m for Gaiam TV, (2-3x P/S)  $120-150m (0.8-1x P/S) for Branded Lifestyle and the bucket of non-operating assets of around $80m. This gets you to a range of $220-260m in total or $9-11 per share.

What’s the downside? Slowdown at Gaiam TV, continued deferral to profitability, lack of take-up and slower roll-out of new Gaiam branded products and delays/cancellation of the split. I’m guesstimating valuation would drop to $110-160m or $5-7 per share (essentially 0.7-1x of estimated forward company sales). Taking the above at mid points you get a downside of $6 per share and upside of $10 per share vs current share price of $7.7.

When you buy into Gaiam you are making large investment in Jirka and his mgmt. team. Jirka owns 25% of the company but controls 75%, via supervoting shares. I guess his experience at Corporate Express lead him make sure that at his next venture he is in charge of his own faith. He has proven once that he can successfully roll-up a fragmented industry by focusing on a niche and he is replicating the same model to an extent at Gaiam.

Your conclusion whether to buy into Gaiam will come down to (i) how comfortable you feel with control situations (I like it when mgmt. is rational) and (ii) whether the above risk/reward is sufficient for you. I’ll be sure to watch the company.