Competitive Strategy – Business Decisions that Strengthened Companies, No Matter the Industry

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I’m launching a new, recurring series called: Competitive Strategy – Spotlight on Decisions that Strengthened Companies, No Matter the Industry. Why am I doing this? Frankly, I am tired of hearing “this is a good business” or “this is a bad business” with some blanket statements behind why. How many times have you heard why a certain company is a “good business”?

  • Consolidated industry
  • Leading national market share
  • Asset light
  • High margins
  • Stable demand
  • Of course, saying a business has a “moat” doesn’t hurt

A company that has some of these features isn’t necessarily great. If you want to learn why (or disagree and would like to hear differing thoughts) stay tuned. I am actually launching the first in the series today – and what better way than to start with a company like Amazon.

A company’s competitive strategy outlines what decisions it will follow every day.

Where it will compete, what segments of the market it will target, where it will choose to scale, how it will use its balance sheet, and what will customers value?

These decisions can result the metrics I mentioned above, but the metrics themselves do not make the business good, or differentiated.

I will go through the competitive strategy of a wide array of companies.  Decisions companies have made / are making to show how those decisions upgraded them from good to great.

I hope to surprise some folks by discussing names that are in “bad” or cyclical industries. Sometimes you can have a bad industry, but a great company within that industry – and sometimes the stars align for a great investment opportunity.

After writing a few of these, knowledge will build and I probably will refer back to previous posts for examples on different company tactics (e.g. hard to not say Amazon Prime is similar to the Costco Membership strategy)

Here is a preliminary timeline of companies and industries I will examine (subject to change). If there are any companies you’d like for me to add, reach out to me in the comments or on twitter and I’ll add it to the queue. Some names may jump to the top if there is enough demand.

Here’s the one’s published so far:

AWS Valuation: Thoughts on the business and whether it should remain part of Amazon

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As cities across the U.S. embarked on huge marketing campaigns to attract “HQ2“, I couldn’t help but ask myself why Amazon was planning a second headquarters. Usually companies like coherence and for the business to act as one under one roof. It is more difficult to do this when you have two “headquarters”. To me, it reminds me of having two CEOs. Two voices. Two cultures. I came to the conclusion that Amazon was preparing for a split up of the company and I would need to think of AWS valuation.

The split would be simple: take the traditional retail business + Whole Foods would go under one umbrella and continue to operate out of Seattle, while the second business would be Amazon Web Services (AWS) and would operate out of its own hub and have its own resources. We should then ask ourselves ahead of time: what is a reasonable AWS valuation.

For those that do not know, AWS is much different than the retail business. It is designed to provide developers quick access to on-demand computing power, storage, applications and development tools at low prices. Thanks to its offering, developers, startups and other companies do not need to focus on infrastructure build out when they are starting a new venture, they can instead focus on their core product and utilize AWS’ resources.

AWS allows faster speed to market in some cases. It also allows this spend to be a variable cost, rather than a high, upfront capex spend.

This led me to ask myself:

  • What do I think AWS is actually worth? Does Amazon’s valuation today reflect its strength?
  • Is AWS actually a good business?
  • Would splitting the company make sense?
  • Is the AWS valuation not factored in to the stock price today?

I think I am going to go through the answers in reverse order. I do think it makes sense to split the company. AWS operates in a competitive environment with the Microsoft Azure, Google Cloud, IBM among others clamoring for a larger piece of the pie. AWS currently has top share of wallet, but it’s a much different business model than the retail business. Here are my three main reasons for splitting the company:

  • Allow focus in areas of strength.
    • Being a company focused on one goal helps keep all employees realize what the goal at the end of the day is: support customers.
    • Today, while a smaller part of the market, there is a conflict of interest with AWS and CPG sectors (e.g. Target announcement to scale back AWS, Kroger announcing post-Whole Foods it would be moving to Azure and Google)
    • Typically in conglomerates, new business in certain sectors can go unnoticed or underappreciated as “approvers” up the chain of command have other things on their priority list. Splitting the company reduces this kink in the chain. This appears to be limited risk today as Amazon is growing AWS and its services, but think about the other segments. Perhaps they are moving slower now in the retail segment or internationally than they otherwise would.
  • Optimize capital allocation
    • AWS is highly profitable from a EBITDA perspective (though is also highly capital intensive today as it grows). On the other hand, Amazon’s retail business is not only low margin, but also is capital intensive and its return metrics are much lower than AWS (especially internationally where the company still has significant operating losses).
    • Even if I think returns for AWS will come down over time (discussed more below), you could view the company as funneling good money after bad (i.e. taking resources from a high return business and pushing it into low return business). If I invest $1 dollar into AWS, I get 28 cents back in year 1 compared to 9 cents for North American retail or losing 11 cents Internationally.
    • You may be optimistic about the LT trends in the retail business and its improving profitability over time, but think about if AWS could funnel more of its cash into higher return projects. It is likely to perform better over time on its own. Freeing up these resources can help AWS invest in its core capabilities and build sustainable competitive advantage.
  • Better align incentives
    • Distinct and clear business with their own performance goals matter when you are paying your employees in company stock
    • Imagine you are a leading employee in the field and asked to work for Amazon. A significant portion of your comp will be in restricted stock that pays out if the entire company does well. But oops, something happens to the grocery business at amazon and the stock falls 20-30%, so now you are well out of the money.
    • Wouldn’t it be better if your performance and the company’s performance were linked?

Note, AWS valuation being underappreciated is not really a core tenant here.

Is AWS a good business?

“I believe AWS is one of those dreamy business offerings that can be serving customers and earning financial returns for many years into the future. Why am I optimistic? For one thing, the size of the opportunity is big, ultimately encompassing global spend on servers, networking, datacenters, infrastructure software, databases, data warehouses, and more. Similar to the way I think about Amazon retail, for all practical purposes, I believe AWS is market-size unconstrained.”

-Jeff Bezos, 2014 Letter to Shareholders

Clearly, AWS has grown like a weed. Amazon has disclosed the results of this segment going back to 2013 and we can see sales and EBITDA have grown at a ~50% CAGR since then and 2018’s pace actually picked up over 2017.

The business started when Amazon brought infrastructure-as-a-service (IaaS) with global scale to startups, corporations, and the public sector. By this, I mean that they provide the infrastructure that allow these companies to outsource computing power, storage, and databases to Amazon. It essentially turned this services into a utility for consumers, with pay-for-what-you-use pricing models. As an aside, what a beautiful competitive decision that was.

As stated earlier, this allows customers to add new services quickly without upfront capex. Businesses now do not have to buy servers and other IT infrastructure months in advance, and instead can spin up hundreds of servers in minutes. This also means you benefit from the economies of scale that Amazon has built up. In other words, because Amazon has such massive scale, it can pass some of those saving on to you. If you bought the servers and other utilized ~70% of the capacity, your per unit costs would be much higher.

AWS has attracted new entrants as well. Microsoft’s Azure and Google’s Cloud have also grown and attracted share. Microsoft provides some color on the business, which I have estimated in the table above, but Google provides basically no disclosure. Other players with smaller market share include Oracle, IBM and Alibaba in Asia.

Despite growth in Azure, Amazon owns more market share than the next 4 competitors combined. And the rest of the market appears to be losing share.

The logical outcome from this, especially when considering how capital intensive the business is, is that the business forms into an oligopoly. Oligopolies traditionally have high barriers to entry, strong consumer loyalty and economies of scale. Given limited competitors, this typically results in higher prices for consumers. Also traditionally, you would expect earnings to be highly visible and would lead to a higher AWS valuation.

However, this is not always the case and it leads me to some concern on the industry. In some cases, oligopolies become unstable because one competitor tries to gain market share over the others and reduces price. Because each firm is so large, it affects market conditions. In order to not cede share, the competitors also reduce price. This usually results in a race to zero until the firms decide that its in the best interest of all players to collude firm-up pricing.

How could this happen with Amazon Web Services? Well, we all now Amazon’s time horizon is very long and it attempts to dominate every space it is in by capturing share with low prices. As said in its 2016 letter to shareholders:

We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.

Jeff Bezos, 2016 Letter to Shareholders

In addition, other competitors have benefited from movement into the space and have been rewarded in their stock price (see MSFT). Clearly others think Amazon’s stock price rise is largely attributed to investors’ valuation of AWS – and that may be true.

But Microsoft ceding share to AWS may hurt their results (and stock price) so they may attempt to take more and more share at the expense of future returns.

In a way, what could happen here is more of a slippery slope. They give a bit on pricing because the returns are so good now that a small price give here and there want matter. But then they add up…

Lastly, its no secret that building data centers to support growth is capital intensive, and that will impact the AWS valuation (see financial table above).

They also serve a lot of start-ups and other businesses. This creates a large fixed cost base for the cloud players. If there was a “washing out” of start-ups, such as the aftermath of the tech bubble, AWS and others could see excess capacity, hurting returns. In order to spread the costs, they may attempt a “volume over price” strategy. This will result in retained share, but hurt pricing for the industry as competition responds.

Unfortunately, I DO think returns are going to come down materially over time. And that will hurt the AWS valuation.

The industry reminds me too much of commodity industries. The industry is no doubt growing today, but the high margins we see today I believe are from high operating leverage. This tends to be more transitory in nature and means that returns on incremental capacity invested go down over time.

Take for example commodity chemical companies. AWS reminds me of some of their business models (unfortunately). Some operate in very consolidated companies, but operate at very high fixed costs and have exit barriers. The loss of one customer results in very painful results due to operating leverage. Although higher prices are better in the long run, the company will lower price to keep the volume and keep the fixed cost leverage.

Think about commodity businesses that reports utilization (note, we have limited disclosure on AWS, but that might be a helpful statistic in the future). Higher utilization usually results in good returns on the plant (or in the case of AWS, server). However, when you lower price on the commodity, the competitors, in turn, will also lower price so they don’t lose their existing customers. What results in lower returns for everyone.

As a another case study, P&G used to run its HR, IT and finance functions within each of its business units. It decided to form one, centralized, internal business unit to gain economies of scale. It actually formed a leading provider of these services. But then, P&G looked at its core business and said, “do I need to continue doing these functions or can I outsource it? Or maybe I can sell this whole business unit to another provider, which would give them more scale and lower the cost of the function”. The latter is what ended up happening. Although it wasn’t viewed as a commodity at the time, these functions began to become more commoditized and business process outsource companies (“BPOs”) now have very high competition and lower returns.

Another analogy would be to at the semi-conductor or memory businesses, though perhaps not as commodity as these two.

I personally think that over time, we will see this form with AWS. The fact that pricing has come down so much for the service (one unnamed engineer I interviewed told me that AWS will even let you know if they think pricing is coming down soon to keep your business). According to the Q3’18 earnings call, Amazon had lowered AWS prices 67x since it launched and these are a “normal part of business.” They’ve certainly been able to lower costs as well so far, but how will that change as competitors also gain scale?

How could I be wrong? I could be wrong in many ways, but the one case is that I am underestimating how “entrenched” the business is into everyday use. That could result in very low switching by customers. It could also mean that developers get trained using AWS so default to using its services. The counter to these arguments is that there is a price for everything and clearly Azure has taken share over the past year, so it’s not proving out thus far. If AWS become the winner-take-all, then I am dramatically underestimating the valuation.

So is it a good business? Well, lets look at at it from a Porter’s Five Forces perspective. I think the view on these, in brief, plus the current returns we can see in the previous tables would point to the industry being solid. My one concern comes back to the competitive rivalry. We can have a high barriers to entry business and highly consolidated, but returns are not good.

AWS Valution: Final Thoughts

Based on the market share numbers posted above, AWS is currently attacking a $73BN market. At the rates that the market has been growing, as well as the additional services, I think its reasonable the market expands to $100BN in the near term, especially as adoption increases.

I assume Amazon maintains its market share due to its relentless focus on lowering price and maintaining share. I think the additional share gained by Google and Azure will come at the expense of the other players included in the market share chart above.

For the reasons stated above, I think this results in returns coming down over time. I still model good returns to be clear, but that the return on assets comes down meaningfully.

This may be hard to read, but I end up with an AWS valuation of $164BN. Given the value of AMZN today is over $1 trillion, even though AWS accounts for over half of EBITDA now, I cant help but think this opportunity is more than priced in, unfortunately.

However, AWS would benefit in the long-term from being on its own for the reasons discussed above. In the short-run, it may get a higher multiple than the rest of the Amazon retail business since its growing quickly with such high margins.

Opportunities in the Muni Meltdown

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First, some personal news. My wife and I have been blessed with our first child, so I’ve been a lot less active on here lately. That said, I’ve been watching the turmoil pretty closely in the market. In particular, the bond market is starting off with one its worst years ever… and it is only April…. And it is happening when the S&P trades off, which is atypical. 

I’ve written before about how bonds probably have a place in your portfolio, despite what you may think of as a low yield. They offer a hedge. Last time I wrote this of course was the last Fed tightening cycle. You would’ve done quite well buying bonds at that time, actually. 

I write this today, treasuries are up, stocks down, with people forgetting about inflation for the moment and fearing whatever other flavor of the month they can dream up of (hard landing in China, War in Europe, Japan devaluation, global recession). 

Despite the barrage of headlines on inflation, I think the risk that still few are talking about is the bust on the other end as the Fed does begin to tighten as demand cools. I wrote about it in my bull-whip post,  and I think a lot of what we are seeing right now can be traced to supply chain issues.

Oil and commodities are a bit different, as they are rising due to the capital cycle playing out as well as another supply chain issue called “war.” Oil price increases, to some extent, is a bit different than just general inflation. 

That all said, as the Fed does slow things down, how many containers of goods are heading here right as demand softens considerably? Hm.

I won’t dwell on this because I doubt I will convince many people one way or another. From my vantage point, I’ll end by saying I am seeing a lot of normalization (or at least things not getting worse) right into a hiking cycle. 

Carnage in Munis

The PIMCO intermediate muni bond ETF is down ~7.5% YTD and the iShares muni ETF is down almost 8%.

That’s tough when starting yields were low. Heck, a 30-yr treasury issued in May-2020 is down 43 points from issuance. Tough when the coupon is 1.25% and the yield is still below 3%.  

However, the carnage leads nicely into what I am looking at buying.

I am in the highest tax bracket and live in Massachusetts. If I can find a 4% yielding MA Muni bond, that’s like finding a near-7% corporate bond. Out of state, a 4.0% muni is still like looking at a 6.2% corporate, as the table below shows.

It isn’t simple to make that comparison, though. High-yield (read: junk bonds) are currently yielding about 6.5%. So finding a corporate bond with equivalent yield to a Massachusetts General Obligation bond isn’t quite apples-to-apples (MA GO bonds are rated AA). 

Can we find any bonds that meet these criteria? 

Part of the “problem” of getting these yields in muni land is you have to accept long term maturity risk, i.e. duration. However on the flipside, locking in a 7% corporate tax equivalent for a long period of time also seems attractive to me.

Further, many Americans own real estate like myself, with 30 year mortgages locked in below 3%. So again, finding a 4% completely tax free bond seems like an attractive use of capital when I am technically short a 3% mortgage at the same time. Let me break down three interesting examples that I found in my search:

Dulles Toll Road (CUSIP: 592643DG2)

The second bond example is the DC Dulles toll road bond. This bond is backed by the revenues generated from the toll road to the Dulles airport of which there are few low congestion alternatives. At 81.625, this bond yields 4.1% to maturity. 

Revenues in 2021 were already coming back to 2019 levels, which supports that this road (and airport) are relatively resilient. Omicron did throw results under the bus compared to budget, but the trend back is obvious. 

For context, 2020 operating revenue declined by 38.2% vs. 2019. Bad, but not “completely shut down” bad.  

You could buy the first lien bonds, but I like the sub notes (third liens) for several reasons. First, the 1Ls are 0% coupon and I’m not going that far (yet). Plus, lien has a segregated reserve fund. The first three liens are funded at the lesser of the standard three prong test: 10% par; 125% average annual debt service (AADS) or 100% maximum annual debt service (MADS).

There are a few attractive covenants (iii and iv matter for these bonds). Rates charged for the toll road must provide net revenue in a fiscal year of at least (I) 200% maximum annual debt service (MADS) of all first senior lien bonds, (ii) 135% debt service of all first senior and second senior lien bonds, (iii) 120% debt service of all first senior, second senior and subordinate lien bonds and (iv) 100% debt service of all outstanding bonds. 

According to the financial disclosures they also have over 2,000 days of debt service costs on hand in cash and there are limited capital improvement projects on the horizon. We could have another pandemic for 6 years and they could still pay interest.

In essence, there is decent coverage here.  

However, due to the pandemic and a development project, this bond is rated A- (but wrapped by Assured Guaranty). I think travel will resume and has already resumed post pandemic and this seems like a strategic asset.  

I am BTFD. 

Mass 2% GO Bond (CUSIP: 57582RN93)

The Massachusetts 2% GO Bond due 2050 (I know, I know, that’s far out but hear me out), was recently trading at 95-100 cents on the dollar. Currently, they are trading at 65 cents on the dollar for a 4% yield to maturity.

This is backed by the full faith and credit of the state of Massachusetts, which I am willing to bet on.

One problem with munis like this is that buying them significantly below par opens up excess discount taxes. These rules are somewhat absurd, but if you buy a muni bond too far below par you may have to pay ordinary income taxes on the discount to par value. That said, in a world where these bonds have some chance of going back to par within the next 10 years. I’d gladly pay that tax.

By my estimates, I could see the potential for a 10% IRR using the assumption that they could go back to 2021 prices at some point in the next 10 years. 

Charlotte Water & Sewer (CUSIP: 161045QQ5)

The last bond is another Charlotte Water & Sewer revenue bond (CUSIP: 161045QQ5). This yield is lower, at 3.70% YTW, but this is a AAA bond (what is the US Federal Gov’t again?). That’s like buying a 5.75% AAA corp bond or a 4.90% treasury. 

Charlotte is a large, growing populace. The raw water sources are ample and the water treatment plants have an average 29 year life remaining. Net revenues are growing, debt is falling, and this also has about 500 days of cash on hand. Did I mention it was AAA? 

$KAR Gets (Less) Physical with $CVNA Asset Sale: I’ll Sell KAR Stock Too

Reading Time: 3 minutesI wrote up KAR stock back in 2021 when investors were confusing secular issues (auctions are becoming more competitive with online presence) with cyclical ones (there just were no cars to sell!).

Now, KAR is selling it’s physical auction business to Carvana in a $2.2BN transaction ($1.6BN after–taxes). This is great compared to pre-sale market cap of $1.6BN (+$1.9BN of corp debt).

Interestingly, KAR says it will only lose about $100MM of EBITDA (KAR did $481MM in 2021). So they sold the physical auction business for about 22x.

 So Ryan, I believe, from a revenue standpoint, the revenue impact is approximately, I believe, $800 million in the current year. And Eric may correct me if I’m wrong. And the adjusted EBITDA impact in the current year are approximately $100 million. As I mentioned, that $100 million is a combination of 3 numbers, the EBITDA of the business, which is the significant majority of that number, I would say, by far. And then revenue from the commercial service agreement, which is a modest sum in the current year. And stranded costs, which is an even more modest sum in the current year, but obviously, some benefit, we think, over time there as well.

They’ll get about 50% of their EV by selling 25% of their EBITDA. Not bad!

The company has been trying to shift more online, acquiring several online auctions and attending podcasts and hosting an investor day highlighting their focus shift.

Here’s the thing: The core to my thesis was that I thought physical auctions were necessary AND a competitive advantage.

Reminder: I used to buy and sell used cars. I bought a couple lemons online and personally, I swore it off. There are simply too many moving parts on a car to capture it in a picture, especially  those that are coming from a lease.

When a vehicle comes off-lease, if the leaseholder and dealer do not purchase the vehicle, the captive finance company then owns it and sells it. Because finance companies do not have dealerships, they use the wholesale market to sells the cars back to the dealer network. Typically a vehicle will enter an OPENLANE closed online auction (only open to that OEM’s franchise dealer network), if it doesn’t sell there it will move to an OPENLANE open online auction (open to all of KAR’s registered dealer buyers), and if it doesn’t sell there it will be moved to/ sold at physical auction.

So why am I selling?

This sounds like KAR is keeping the great parts? Doesn’t the KAR stock look cheap now with all that cash?

Maybe, but I don’t want to own this anymore. It is against what I firmly believe the industry requires to move volume efficiently. So, so, so many cars actually end up going into physical auction. And I think having this integration is actually valuable. I don’t have the numbers on me, but the last two years are irrelevant anyway.

Online is less capital intensive (theoretically…), but it isn’t clear to me who the “winner” will be long-term. I worry about that. Clearly KAR has acquired several online platforms that weren’t around just a few years ago.

If OPENLANE wasn’t the obvious winner (i.e. they had to acquire other players to augment it), why would it be in the future?

I somewhat doubt that because of this, KAR stock should trade at a structurally higher multiple. Could be totally wrong.

Oh, and last thing, KAR has a pref that converts at 17.75, so share count is going up 29% (my math it goes from 124 to 159-160, could be wrong though). I knew this going in, but given all the moving parts, I am closing out here.

I have the pro forma KAR stock trading at ~9x PF EBITDA ($3bn market cap, $100MM net debt vs. $345MM of EBITDA). That screens somewhat cheap, but I’m not staying along.

Apollo Buying Tenneco $TEN – Highlights Value in Auto Suppliers

Reading Time: < 1 minuteHere’s something you don’t see everyday in efficient markets: A company being acquired for a 100% premium.

Tenneco is being acquired by Apollo private equity for 100% premium to yesterday’s close. It’s not a premium to is 30 day VWAP or the premium 90 days ago before a rumor of a sale came out. 100% overnight. Amazing.

Tenneco was trading at 3.8x 2022 EBITDA coming into today. Tenneco was pretty levered ($5BN of debt compared to $1.5BN of ’22e EBITDA is 3.4x levered for a business trading at 3.8x, so the equity was a stub). So it isn’t like this multiple is crazy.

Similar to many auto suppliers, they often look optically cheap, but in what I highlighted in my prior posts on suppliers, I actually think THEY ARE CHEAP driven by fundamentals and improvements in FCFs, etc. etc..

It gets better.

What does Tenneco do? They serve a lot of internal combustion engine (ICE) parts! Clean air products (for emissions), powertrain parts (pistons, spark plugs, seals and gaskets for engines).

Certainly interesting to see private equity sees value as well!

Earnings Check-in: Maybe I’ll Learn It’s *Never* Priced In $VMEO

Reading Time: 2 minutesVimeo reported Q4 earnings yesterday and given they provide monthly stats, Q4 was not earth shattering. It was all about the outlook. As they say, let’s talk about the good, the bad, and the outlook.

With the stock down 31% from prior close at the time of writing, and down 83% from spin, the outlook was ugly.

Here’s the guide, along with the announcement that the CFO is out (I think someone’s head had to roll):

I wrote one time before that “things you think are priced in… are not” and maybe one day I’ll learn from that advice.

When I wrote up Vimeo a couple weeks ago, I highlighted all the reasons why investors were shunning it: growth decelerating, clearly a COVID beneficiary, management lost credibility as they were already under their 5 year target….

That said, I thought Vimeo was still a solid business at the end of the day and much of this was “priced in.”

If you take a long-term view, hammer estimates, you could earn a solid IRR. Well that’s not the case in the short-term!

Live and learn. Anyway, there are some bright spots outside of the headlines, but many puts and takes:

  • Mgmt admitted they were naïve about the COVID benefit.
    • That’s positive I guess, but might still mean they don’t really know where things 2, 3 years from now will shake out.
  • NRR actually dipped below 100
    • Mgmt attributed to COVID overbuying (and kind of suggested that since it is holding in so well, maybe that shows how sticky it is, but meh)
    • They think their new pricing will cause NRR to fluctuate short-term. But they also pointed to it improving long-term (over the balance of the year) and that it is a lagging indicator
  • Landed a 3-yr, 7 figure customer to highlight upsell is working. Customer will use video library for training and such.
    • This is a win, in their view, because VMEO just started the beta for this 6 months ago. It’s also a proof of “where the market is going”
    • Again, when your ARPU is ~$260, this is a large incremental
    • That said, when we think about the guide, if VMEO is winning more of these customers, shouldn’t that be a huge tailwind to growth?
  • EBITDA is likely negative this year as they plow money into a sales team effort to convert customers.
    • Puts and takes here: if the LTV / CAC makes sense, go for it.
    • I think it likely does, but mgmt flubbed their answer on the call, didn’t get specific which likely hurts them
  • Chief Revenue Officer from Adobe has started. Many people may remember Adobe was a pioneer in navigating customers to software subs.

That’s all for now. When a stock like this gets hammered, you know you are a bag holder when you start asking what the brand is worth!

Vimeo committed a felony. I knew it was coming and didn’t care. That’s a lesson. But I am sticking with it for now.

Service Properties Trust – A Special Situation with a Catalyst $SVC

Reading Time: 6 minutesQuick idea today: I am looking at Service Properties Trust (SVC). I think the idea is interesting and there is a catalyst. Here’s the situation:

  • Company Overview: SVC is an externally managed REIT (managed by RMR – more on this later), owning 304 hotels and nearly 800 “service-oriented properties” which are net lease
  • Glance at the Opportunity:
    • $1.4BN market cap, $913MM in cash*, $7.14BN in Debt = $7.7BN EV
    • Tangible book $10.62 vs. stock at $8.61 = 19% discount to book value
      • Book value likely underestimates the net lease portfolio value
      • Book value is also depreciated – i.e. the assets bought many years ago likely didn’t go down in price from the price paid, but accounting is accounting. Depreciation is $3.5BN of value – think about that in the context of the market cap.
      • See Value Build table below. You could arrive at $40 implied stock price depending on what you want to believe. I used 7% cap rate for the net lease portfolio which is a decent discount to a recent comp.
    • You can also get to ~$12 stock using 12x EBITDA, which is 37% upside, and ignores a lot of other things I’ll mention. True value likely is somewhere in between these data points.
    • The cap structure is overlevered, they have a $500MM of bonds due Aug 2022 and the $1BN revolver is technically due as well.
      • *They have $1BN drawn on revolver. The rest of the debt is unsecured bonds.
      • The revolver draw isn’t all bad – they transitioned ~200 hotels to Sonesta in 2020/2021 and thought it had a chance of being disruptive, so they did it out of abundance of caution. It *was* disruptive when you add in COVID lock-downs, but both are looking like they are in the rear view mirror.
      • In some ways, this reminds me of CPLG, but sketchier – CPLG owned hotels and leverage got a bit too high. But CPLG sold poor-quality hotels at amazing levels, delevered and create value. Eventually they sold the whole business.
    • Bottom line: Given this is a levered equity, if you think the enterprise value is too low, that likely means the equity stub could have A LOT of upside. But also means A LOT of risk!
  • The Assets – Hotels and Service Properties:
    • The hotels are managed or operated by franchisees of Sonesta (261 hotels), Hyatt (17 hotels) or Marriott (16 hotels), etc.
      • About half of these are extended stay hotels, with the other being a mix of mid-level to some luxury. But luxury is in the eye of the hotel-er.
      • The hotels are recovering from COVID nicely, but no where near peak. The company did provide monthly operating stats in their deck which is nice.

    • The Service Properties / net lease portfolio came from the SMTA acquisition, which was a special situation if anyone followed it
      • The largest tenant in the net lease portfolio is TravelCenter of America (45% of minimum rent owed, but larger on a $ value basis – likely 60%)
      • TravelCenter is public (ticker: TA) and is a full-service truck stop.
      • TA is doing quite well fundamentally. Looks like EBITDA has doubled LTM 9/30/21 vs. 2018. Haven’t fully dug in, but seems like if trucking in America is doing well, TA is doing well.
      • Other tenants in the net lease portfolio include Shopping Centers (20%) AMC (2%), The Great Escape (2%), Life Time Fitness (~2%), and a tail of others. You can imagine many of these were battered by COVID, but mattered less compared to TA and Shopping Centers.
      • Either way, the company is collecting 100% of rents now and the portfolio is 98% occupied with well staggered maturities. I encourage you to check out the investor deck for more.
  • What else makes this interesting?
    • The situation is hairy: RMR involvement (I’ll get to it) and a levered equity. The latter tends to produce high returns if you get the entry point right and you think the B/S is fixable
    • Abandoned REIT: SVC had to cut its dividend during COVID. Went from 54 cents to a penny.
    • Catalyst: Currently marketing 68 hotels for sale ($579MM of carrying value). Mgmt stated they expect to get at least carrying value in Q1’22.
      • Mgmt said they have term sheets on all properties, though one is a bit more complicated. I suspect we will see staggered announcements to multiple buyers
      • Sales proceeds will first go to refi the bonds and likely downsize and extend the revolver
      • These assets for sale lag the rest of the portfolio in earnings or had deferred capex (read: bottom tier). It also reduces hotels vs. net lease portfolio. Net / net RemainCo should be valued higher.
      • Selling these assets and taking out the impending maturity can act as a cleansing event for investors to come back to the stock
    • REIT M&A remains hot, provides comps:
  • Other Value:
    • SVC owns 8% of TA equity and 34% of Sonesta Holdco. The former is worth about $51MM, the latter I am not sure as they are not public.
      • RMR earns fee on managing Sonesta. We can infer Sonesta makes about $750MM in revenue (0.6% fee on all revenue per RMR 10k)
      • We just saw CPLG get acquired for 2.8x revenue, which would imply $2.1BN EV here.
      • Assume 60% debt / cap (total guess) = $1.26BN of debt and $840MM of equity, implies about $285MM of value for SVC. This is all a wet finger in the air and the carrying value of the investment is $62MM. I use carrying value.
  • Value Build
    • Here is the value build of what I have so far

    • There’s only one thing I haven’t talked about so far and that is the remaining 236 hotels.
    • The table below is how I got that number and it goes back to that depreciated book value discussion.
    • SVC’s lodging-REIT roots trace back to 1995. It isn’t out of the realm of possibility that many of those assets are depreciated considerably.

  • RMR / Intercompany Relationships:
    • RMR manages SVC. SVC owns a lot of Sonesta hotels and owns 34% of Sonesta. SVC owns a lot of TA properties and owns 8% of TA. RMR provides management services for Sonesta and TA!
    • Let me be clearer: RMR manages both sides.
    • I should also mention people have a lot of misgivings about RMR and the Portnoy’s who manage it.
    • Let me copy the statement straight from RMR’s 10-k:

    • Perhaps you can see the risk here. RMR might try to rob Peter to pay Paul. RMR makes more money from managing SVC than it does from Sonesta (like… a lot more. 10x more. $45MM vs. $4-5MM).
    • That said, the web of inter-ownership perversely provides some comfort (admittedly not a ton). Screwing part of the chain should ripple back through and solve nothing. And again, RMR makes more from SVC. If there is a transaction, it is to preserve value at SVC.
    • On the other hand, I will admit an outright sale of SVC isn’t likely. I doubt RMR does that.
  • Are there any signal of what RMR could do?
    • RMR also manages Diversified Healthcare Trust (DHC) which had some liquidity and covenant issues
    • RMR went out and found institutional investors for some assets, from my understanding not all core, which DHC contributed to a JV.
    • They did this recently in Jan-22 at a 5% cap rate but also at the end of 2021. Net / net, it looks to be about a $1BN of value realized.
    • It allowed DHC to get some liquidity, get a real bid on the assets, but not lose all economics
    • Why does this matter?
      • I think if your one hang-up is leverage, I think there are many solutions in addition to selling these non-core hotels in Q1.
      • If your one hang-up is RMR, then I think they’ve shown they are acting in the best interest of the company. RMR is aligned as they earn management fees on the enterprise values of the companies. They also manage the JVs in DHC’s case (lol)
    • Did RMR tip there hand to this??

That’s all for now – stay tuned for the asset sale announcements!