A Wealth Creation Journal

Category: Investment case

Live Portfolio Update – 2021 – #19 (Netease)

Bought a 2% position in Netease @HKD 149 per share.

In my mind, Netease is almost the perfect game company – a DNA of game as a service, a healthy stream of cashflow from existing game portfolio and a proven game development track record. See previous post on game as a service vs game as a product.

To translate the above business characteristics into cashflow terms, it means that Netease’s existing games can generate stable and even slightly growing cashflow for a very long period of time. And Netease’s ability to develop new games only adds to this base of stable cashflow.

Unlike many successful game companies, Netease’s founder, Ding Lei, has proven to be a very capable capital allocator who owns 50% of the company. Few Chinese internet companies pay regular dividends and maintain a single share class structure like Netease. What’s even more impressive is that Ding Lei has successfully incubated new businesses beyond gaming with varying degrees of success. Netease cloud music is the best online music platform in China while Youdao (spun off to list in US) is the most popular dictionary app in China. Ding Lei’s forray into e-commerce has been less impressive but it managed to recoup investment cost by selling the business to Alibaba almost at cost in 2018.

Going forward, Netease’s next leg of growth could come from expanding its gaming business globally. It would take a long time but I think Netease can eventually crack it.

There are a lot of concerns about gaming regulation in China. My view is that 1) shorter term, minor gaming revenue is only low single percentage of Netease revenue 2) I am confident that minors will embrace gaming as they grow older because gaming as an entertainment format is superior. By regulating one of the major negative externalities of gaming – minor addiction to gaming, it is in fact more sustainable for the industry long term.

At roughly, Netease is roughly at fair value at 20x core gaming earnings and growing earnings at a rate of 10%. This is a business that I would love to buy more at lower valuation

Live Portfolio Update – 2021 – #16 (Beijing Capital Land)

Investment Action: buy 3% position in Beijing Capital Land @HKD2.5 per share

Offer price: HKD 2.8

Current share price: HKD 2.5

Upside: 12%

Probability of success: 90%

Beijing Capital Land is a SOE real estate developer that is majority owned by the Beijing Capital Group which is in turn fully owned by Beijing SASAC (SASAC is the department that manages state own assets). And it is currently being privatised by Beijing Capital Group through a cash offer of HKD 2.8 per H share. In short, Beijing city government is buying the minority shareholders of Beijing Capital Land.

Beijing Capital Land was first listed in 2003 in HK stock exchange and its total return since IPO reflects the quality of the business. In 2020, Chinese government started to cap the leverage employed by real estate developers through three measures – 1) liability to asset ratio, 2) debt to equity ratio and 3) Cash to short term debt ratio. If the real estate developer is determined to be too leveraged according to the three metrics stated above, then the developer cannot increase total leverage. In essence this is very similar to the prudential regulation faced by banks. This sparked off a wave of either equity issuance, asset sales and/or price discount on new home projects to recoup cash in the Chinese real estate sector.

Unfortunately for Beijing Capital Land, it does not meet the debt to equity ratio and cash to short term debt ratio. Within this context, the parent company is privatizing Beijing Capital Land such that it would be in a better position to inject equity into the developer and meet the regulatory standard.

Despite the offer price of HKD 2.8 carrying a whopping 62% premium over the last trading price before announcement, the offer price implies a price to book ratio of 38%. So valuation also make sense for Beijing Capital Group

And the deal would require ~HKD 5.3bn of cash which Beijing Capital Group can easily finance out of its own balance sheet.

Live Portfolio Update – 2021 – #13 (Soho China)

Bought a 3% position in Soho China at HKD 4.45. This is a simple merger arb and I see it as a better-than-cash investment opportunity.

Blackstone is making an all-cash offer for Soho China at HKD 5 per share which translates into an 11% upside from current share price of HKD 4.5.

Time to closure: I expect the deal to complete within 8 months which gives a pretty decent 15+% IRR. There is some risk that this deal could take longer

Probability of Success: 90%.

  • Blackstone is a reputable real estate PE firm and the founders of Soho China are very well-known figures within the Chinese business community. I think it is very unlikely for the deal to fall apart.
  • The price seems to be fair for both parties. Blackstone can see some upside from this transaction as there should be quite some room to improve rental income by improving occupancy rate and general recovery from COVID-19. And maybe there is a little upside from rerating from cap rate. The current cost of debt is ~5% and Blackstone could probably lower it once they gain control. Finally there should be some 2-3% of the like-for-like rental price growth annually
  • For Mr and Mrs Pan, this is a reasonable valuation for them to exit the business. Building office space seems to be a very structurally challenging business in China due to intense competition and the rise of shared working space. Soho China’s premium office space positioning has helped to insulate them from the most intense price competition.
  • Given that it seems like a fair deal, then both sides should be motivated to close this transaction.
  • I don’t see material regulatory issues as Soho China’s market share is low and office space is not a sensitive sector
  • There is a general risk of unanticipated events happening and I am not too intimate with the parties involved

While the probability of failure is low at 10%, the downside from the deal not going through is very high at over 50% using the pre-announcement share price of HKD 2-3.

All things considered, I am only committing 3% capital as I would not consider Soho China a favorable long-term investment in the case of deal failure.

Investment Memo – Stitch Fix – AI-first fashion retailer

Stitch Fix is a fashion retailer in the sense that they take inventory, do merchandising, buy at wholesale price and sell at retail price. But that is about where the similarity with a traditional retailer ends.

Stitch Fix’s business model involves users submitting detailed body measurement data and style preferences which is then used to feed into the Stitch Fix machine learning model. Stitch Fix will combine algorithm recommendation and the wisdom of a human stylist to pick out 5 pieces of clothing and sent them to users in a box which is called a Fix. Users don’t know what clothes they are going to get until they receive it. So there is a surprise and delight element. Users will pick what they like and return what they don’t like. Continue reading

Investment Memo – CD Projekt

I bought some CD Projekt shares in my previous portfolio update here. I am very excited to finally become a partner in this wonderful business after following it for 3 years.

I will first discuss CD Projekt’s business at a high level and then go into the recent debacle with Cyberpunk 2077.

As I wrote in my previous blog post – Thoughts on video games:

As an investor, I prefer game companies with incredibly strong game franchises and a proven game development track record. There are very few game companies that fulfil both criteria. Netease, Tencent and Nintendo are some examples. The goal is to buy such game companies at a discount to its existing game franchise value and future game value is margin of safety.

CD Projekt has one strong game franchise – Witcher and in the process of building out a second franchise – Cyberpunk. Despite the launch drama, I think CD Projekt has a reasonable track record as a game developer. So CD Projekt does not fulfil those two criteria – owning strong game franchises and proven game development capabilities – very convincingly.

But I think there is sufficient evidence that CD Projekt can continue to develop its capabilities and strategically build out future game franchise. So there is not really a lot of margin of safety here and hence this is a 2% position.

I always prefer game companies that own and operate persistent game worlds which provide game-as-a-service revenue model rather than game-as-a-product revenue model. Unfortunately, CD Projekt adopts the game-as-a-product revenue model which means its cashflow is very tied to game releases and very dependent on the success of each game release. This has historically lead to a hit-driven business model which many investors hate because it is impossible to predict the sustainability of the company’s earnings.

This has been my biggest reservation about CD Projekt. But a few things changed my mind – 1) the launch Witcher mobile game; 2) the launch of Witcher Gwent card game, 3) the planned launch of Cyberpunk multiplayer online game and the 4) the release of Witcher series on Netflix

In some sense, CD Projekt has a very similar business model to Disney. Disney use movies to anchor its IP franchise which can then be further monetised through theme parks, merchandises and video games. For CD Projekt, it anchors its game franchise with flagship AAA games such as Witcher 3 and Cyberpunk 2077 and then develops spin-off games based on these core game franchises. It also produces TV series to further expand the influence of its game franchise.

CD Projekt’s real upside comes from 2 sources – 1) it builds out new game franchises and 2) transition one or more of its game franchise into persistent game worlds which can build strong customer loyalty and generate stable cash flow. With Witcher mobile game and the planned release of Cyberpunk multiplayer game, we are already seeing some signs that it is happening.

On valuation – it is very hard to value CD Projekt. As part of the company’s incentive program, it announced a goal of generating an average net profit of PLN 1.5-2bn for the period between 2020 – 2025. Assuming that they hit this goal, then I paid 15x multiple based on earning base of PLN 1.5-2bn net profit. Not too ridiculous but also not very cheap.


CD Projekt share price plunged after the disastrous launch of one of the most anticipated game in 2020 – Cyberpunk 2077. Here is a good Bloomberg article that documented the events that lead up to the game’s launch. In short, Cyberpunk 2077 built up an incredible hype but ultimately disappointed gamers as the game was full of bugs and glitches. It was so bad that Sony had to take the game off the shelves because it was almost unplayable on consoles.

Marcin, the co-founder of CD Projekt, posted a video to apologise for disappointing gamers and explain what happened.

He cited the technical challenges of making the game work with the next-gen and current-gen console & COVID-19 restrictions leading collaboration challenges as reasons for the failed launch.

From the outside, it is absolutely clear that the management team had huge pressure to get the game released before Christmas 2020 and that pressure led to the bad decision of launching before the game is ready. I am sympathetic to the challenge of COVID-19 situation which would have really complicated the entire development process.

The legendary game developer, Shigeru Miyamoto, once quipped that “a delayed game is eventually good, but a rushed game is forever bad”. This comment was made when games are primarily sold on physical copies and played with consoles that had no Internet connection. So there was no way to update the game after launch.

Fortunately, CD Projekt (CP) lives in the Internet era where it is possible to continuously update and improve the game once launched. In fact, Witcher 3’s launch was very problematic too. See this Eurogamer article written in 2015 to recount the disaster! And it feels eerily similar to Cyberpunk 2077 – last-minute crunch, graphic downgrade issues and the 2000 game bugs. Post-launch, CD Projekt continued to support Witcher 3, patched the bugs, launched DLC and won universal praise for the game. I believed something similar is going to happen here and that Cyberpunk has the potential to become another great franchise.

Ever since CP transitioned from a regional game distributor to a game developer in the mid-2000s, CP has been pushing its technical and game-making competence with every game. With Witcher 3, CP had to make a game engine that worked in an open-world while developing the game at the same time. CP has insane ambitions to grow as a world-class game developer.

I think with Cyberpunk, CP was trying to push the limits of what they can accomplish again. For example, they had to upgrade the game engine for FPS and driving. The Cyberpunk world was bigger and more complex. Except for this time, they had the complication of COVID, higher expectations, bigger gamer base and co-existence of two generations of consoles.

CD Projekt clearly screwed up this time. But from an investment perspective, I focus on three things – 1) what does this incident show about the company’s game development capabilities, 2) what does it reflect about the company culture and 3) the long-term potential of Cyberpunk 2077 franchise.

For me, it seems like CD Projekt’s ambitions might be ahead of its game development capabilities this time. But it is also clear that CD Projekt is improving as a game developer and based on the company’s historical track record of learning from mistakes, this could be another learning opportunity for CD Projekt albeit an expensive one. I am more concerned about how this incident could crash their ambition and kill the operational momentum that they have been on.

Few game companies have developed such a strong brand within the gamer community. CD Projekt always believed in treating gamer well which is exemplified by their ethos of providing good value for money – free DLCs and DRM-free games. I personally don’t believe there is anything sinister going on here except for the fact that there is immense pressure to release before Christmas 2020. During game development, there are constant trade-offs to be made and we could argue whether CD Projekt has made all the right trade-offs. But I don’t think there are any bad intentions here. I guess we will see how CD Projekt make up to the gamers in the months ahead.

After reading through many reviews and playing it myself, I think it is a good game and has the potential to become another long-running franchise for CD Projekt in the same way as the Witcher franchise.

Ultimately, I think there is a pretty good chance that CD Projekt can bounce back from this fiasco and become a better game company in the process.

Ryman Healthcare – Update #5

Finally! I executed my first share purchase since the beginning of this crisis. I bought some Ryman shares @ NZD 10.45. It is a relatively small position now (~2%) and I aim to buy more if situation becomes favourable again.

Ryman Healthcare is a company that I have been following for more than one year now. I really started to do work on the company in Nov 2019. It is the largest retirement village operator in New Zealand. Globally, retirement villages are typically average businesses but there is one little quirk about retirement villages in New Zealand that completely transforms the economics of the business. For most real estate asset developers, there are really two ways to generate profits – either sell the assets for a profit upon completion or rent the property to collect the fixed income.  For example, most residential property developers would sell the asset upon completion while shopping mall developers often choose to rent the retail property as the long term rental growth would generate a higher return over time. The IRR is better if the property is sold upon completion while the rental model has lower IRR initially and can be more profitable over the long-term if rental growth is respectable.

But is there a business model in which the property is sold immediately upon completion while also retaining the right to collect rental payment over time?  You know, have the cake and eat it too.

Turns out that is exactly Ryman’s business model.

It builds retirement villages and “sells” elderly folks the right to live in their villages. The resident pays a deposit that is roughly equal to the value of the retirement unit. Ryman would charge up to a maximum of 20% of the deposit value as a management fee and the residents are granted the right to live in the retirement unit for as long as they wish to. At the point of exit, the resident is paid back 80% of the original deposit. In reality, most residents only stay in the retirement villages for 6-7 years on average because the average entrance age is more like 75+. This business model allows Ryman to recycle capital on day one through the deposit (great for IRR) while retaining the ability to collect fixed payment through the form of the management fee.

So why do the elderly folks chose to move into a retirement village? Many elderly folks find it very hard to maintain their large house as they get older. Property management service provided by the village operators relieves them of these chores. Another important motivation is a change in life circumstances such as the passing of one partner. Many prefer to live in a close-knit community than living alone. There is the hospitality aspect of living in retirement villages. There are weekly drinks, movies, field trips, exercise classes, and parties. It is kind of like living in a hotel with strong healthcare capability. Finally, a move into a retirement village helps to release equity in their home which can be used to finance their lifestyle.

New Zealand has a rapidly ageing population which will see the 75+ population grow by  ~3.5% for the next 10 years. The supply of retirement village is growing 5% and hence the penetration of retirement village is growing. The retirement village sector is ramping up supply to meet the growing demand; I would keep a vigilant outlook on the pipeline of new supply. However, Ryman should continue to do well relative to its peers because its villages offer better value for money.  Ryman charges 4% management fee p.a. capped at 20% while most competitors charge 5-6% management fee p.a. capped at 25-30%. Furthermore, people will always want the best care and safest pair of hands to take care of them in the twilight of their lives. They also need to trust operators that don’t take advantage of them when their mental and physical states are not in the best shape.

Hence Ryman’s competitive advantage comes from its reputation as a high-quality care provider and a trust-worthy retirement village operator. It offers a continuum of care model for its residents where independent units (normal houses with minimal care provided) and care centres (including hospital care) are on the same site. Elderly folks are not the most flexible bunch. Ryman pays its care staff above market rate to provide premium care and a strong culture of care.

The market also clearly acknowledges Ryman’s superior quality as its valuation is twice of its peers such as Summerset, Oceania and Arvida. Despite the valuation premium, I prefer Ryman over its peers as a strong culture of care is the best protection for long term franchise value. For example, I have found Summerset to have a mercenary attitude as compared to Ryman. This is not to say I will not invest in Summerset. Just that I think the valuation premium is at this moment reasonably justified. While I believe that Ryman is the best operator in the sector, the entire sector is likely to do well given the favourable economics of the business model.

If I am asked to buy the entire business (which I do sometimes fantasize about), I would value Ryman in a similar manner to an asset management company in that it clips ~3% of the total capital base. The capital base is generated by resident deposits. If I assume that Ryman builds out its existing landbank in the next 5 years without adding to the land bank, it would be able to generate, in my estimation, ~NZD 200m of incremental earnings. Note I exclude new sales gain from this analysis. Putting on a 25x earnings multiple, it would imply a share price of ~NZD 12. I think 25x is reasonable because the capital base enjoys 2-3% of house price growth even if there is no unit growth. This is comparable to the 4-5% rental yield in New Zealand. Of course, in reality, Ryman will maintain its land bank for growth beyond 2025. Hence our entry price is a very attractive one.

Now let me address the elephant in the room – can Ryman survive current pandemic?

  1. Ryman’s care revenue is well protected even in a national lock-down as the residents still live in the care centre. New residents are allowed to be admitted because these are typically need-based demand. Of course, there will be stringent isolation protocols in place
  2. Ryman’s care revenue more or less covers the fixed cost of the entire company. So they have liquidity to cover fixed cost even in a prolonged lock down situation
  3. New sales activity will cease but the company has a lot of leeways to stop existing construction projects to conserve cash. As of Sep 2019, the capital commitment is NZD 150m.
  4. Resale activity will cease too and this would impact Ryman’s ability to repay resident deposits on exit. Typically, Ryman promises to repay the deposit within six months after which Ryman will pay ~1-2% interest on the deposit. Legally, Ryman has three years to repay the resident. Even if we assume that COVID-19 lasts for 3 years (super unlikely in my view), Ryman can sell the apartment to pay back the resident
  5. It has roughly NZD 300m of liquidity headroom in an NZD 1.9bn credit facility. The credit facility is secured with underlying assets.
  6. According to the company, there are two main covenants – interest rate cover and gearing ratio

Given the above facts, it seems that Ryman has a very high probability of surviving this crisis.

The demand for Ryman product is mostly like to be delayed and not lost. Hopefully, we should see a reasonable demand recovery.

There is a risk with house price deflation in the event that we go into a recessionary environment coming out of this pandemic. Even though Ryman’s units usually sold at a discount to comparable houses in the same market, it would still impact Ryman because elderly folks need to sell their house to afford a Ryman unit.

Dart Group – Mar 2020 Update

I am re-evaluating how much Dart Group (DTG) could be worth coming out of this crisis. In considering the reasonable price to buy DTG under the current conditions, one would evaluate the following factors – 1) chance of DTG survival (liquidity analysis); 2) loss incurred during this crisis, 3) competitive landscape, and finally 4) the normalised earning power coming out of this crisis.

1. Chance of survival

Based on GBP 1.5bn of cash and roughly GBP 800m of the annual fixed cost base, I estimate the following chances of survival. In theory, DTG can sustain itself for an entire year based on the current liquidity profile. However, there are a few catches. DTG customers pay upfront for their summer holiday. Typically Jan and Feb account for a bulk of the summer holiday bookings. If the current lockdown extends into the summer months, customers would want their refunds. This could severely impact the liquidity situation if it so happens. Many UK travel companies are issuing Refund Credit Notes (RCN) that is backed by the UK package holiday regulator, ABTA, to avert the liquidity crunch. In the case of travel company failure, consumers can buy another holiday using the RCN. ABTA’s backing ends on 31 July 2020 after which customer can demand cash repayment if they have not used the RCN to book another holiday. On the hotel side, DTG typically buys up some capacity to guarantee supply quality. DTG would have to balance the long term commercial relationship and the short term need for cash. Given the level of unprecedented fiscal and monetary policies that are announced, the government’s willingness to intervene is strong. While I would not count on that necessarily, it is a factor in considering the chance of survival.

Length of lockdown Chance of survival
3 months 99%
6 months 80%
9 months 75%
12 months 70%

The main point here is that on balance DTG’s chance of survival is very high even in extreme scenarios.

2. The loss incurred during this crisis

The first step to estimating the possible range of loss sustained in this crisis is to estimate the revenue decline. I used Jet2’s monthly traffic in 2018 and 2019 to approximate the amount of volume decline and layer on price declines.The table below shows the weight of each month traffic as % of the full-year traffic. So if we assume a three-month lockdown, there would be zero revenue in Apr / May / Jun which meant a loss of ~30% of full-year traffic. The actual traffic loss is going to be greater than 30% because the process of demand recovery is going to take time. For simplicity sake, I will use 5% to account for the volume loss during the demand recovery process.

Length of lockdown Volume Decline Price Decline Revenue Decline
3 months 35% 20% 50%
6 months 75% 20% 90%
9 months 90% 20% 95%
12 months 100% n/a 100%

The assumption of the price decline of 20% might be too generous but it does not really matter. Because the point of this analysis here is to show that the revenue decline is close to 100% as long as the summer months are lost.

2018 2019
Jan 3% 3%
Feb 3% 3%
Mar 4% 5%
Apr 6% 6%
May 10% 10%
June 13% 12%
July 14% 13%
August 15% 14%
September 13% 13%
October 10% 11%
November 5% 5%
December 4% 5%

Assuming 3-6 month of lockdown and a fixed annual cost base of GBP 800m, the loss incurred is likely in the range of GBP 400-800m.

3. Competitive landscape

On the supply side, the materially higher debt level will limit growth capex in the next 2-3 years. This would provide a favourable backdrop to medium term (2-3 years) ticket price recovery. However, it also provides an opportunity for new entrants with a clean balance sheet to compete against the incumbents as they don’t have to carry the cost of debt. On the other side, many smaller competitors will probably go out of business and free up more demand.It is not clear what this means for Easyjet’s venture into the package holiday. Maybe they are less committed to a large marketing budget to support the new business. Or maybe it doesn’t cost that much to push the packaged holiday business.For Tui, I think DTG is likely to come out of this in a stronger position relative to Tui as DTG’s balance sheet is stronger and a lot less asset-heavy versus Tui. Tui’s offline distribution network is going to be massive cost drag while DTG relies on more nimble independent travel agents.Generally, I do expect DTG to come out stronger relative to its core competitors.

4. Normalised earning power

Assuming that by 2024, the traffic volume is back to 11m per pax vs 14m in 2019. And assuming a pre-coronavirus ticket yield of GBP 82 and average holiday price of GBP 680, DTG’s leisure revenue looks like GBP 2.4bn. Putting an 8% EBITDA margin on the top, DTG would be making GBP 200+m. The normalised earning power is probably ~ GBP 150m. With a 10x multiple, DTG is worth ~ GBP 1bn. There would probably be another GBP 100-200m of net debt. That leaves the equity value around GBP 800m.So given the risk-reward and the opportunity cost, I would consider buying DTG shares around GBP 300-400m market capitalisation which gives me an IRR of 25%.

Games Workshop – An Investment Fantasy

Games Workshop (GW) is the largest investment (20%) within my portfolio as it is the cheapest and simplest idea that I can find. When GW ownership was first acquired in April 2018, I only committed 5% of total investment funds because I did not fully appreciate GW’s outstanding business quality. Despite the share price increasing from GBP 22.75 to GBP 61 since then, I further increased the investment in GW as my understanding and conviction in the business developed positively. I may be a slow learner, but it is better to be late than never.

GW is the UK-based creator of Warhammer Hobby which makes fantasy miniatures set in endless, imaginary worlds called Warhammer Universe. The Warhammer Hobby involves painting and collecting Warhammer miniatures with rich backstories developed over 500+ Warhammer novels in the last two decades. Fans can form armies with the miniatures to participate in the tabletop wargaming with the rules developed by GW. All miniatures are designed and manufactured in the company’s headquarter in Nottingham. The story writers collaborate with miniature designers and game makers to weave new characters, games and stories seamlessly together. GW generates revenue through the sales of miniature and the royalty income from licensing its intellectual properties (IP) for PC and mobile games.

I think of Warhammer fan base in three categories – Collectors, Gamers and IP fans. The Collectors preoccupy themselves with collecting and painting miniatures because of their design and beauty. The Gamers are passionate about the wargames and strategically acquire miniatures based on their roles and powers in the game. IP fans, fascinated by the Warhammer Universe, mostly enjoy the Warhammer novels. In reality, the fans have one main preference but also participate in other aspects of the hobby in varying degrees. Interestingly, the Collectors make up for 30-40% of GW’s revenue.

While not everyone is a natural fan of the Warhammer, those who carry the Hobby Gene have an innate tendency to become a fan. This love affair between fans and GW was under trial during the period from 2010 to 2015. Under the leadership of previous Games Workshop management, the company had minimal communication with the fan community, shun social medial (because they did not want to deal with criticism from the fans), closed down popular product lines and increased prices excessively to offset a shrinking fan base. During this 5-year period from 2010 to 2015, the revenue shrunk from GBP 126.5m to GBP 119.1m while the net profit declined from GBP 15.1m to GBP 12.3m.

Just when it seems like GW is set on an inevitable slow decline, Kevin Roundtree took over as the new CEO of Games Workshop in 2016. The first thing he did was to reconnect with the Warhammer fan base through the Internet. Then, he reintroduced the popular Warhammer games that fans loved. Most importantly, he makes it easier for fans to get into the hobby by offering lower price point starter sets and simplified the game rules. The fans are elated and came back into the hobby in droves. One fan even commented that “it is like Games Workshop was taken over by someone who actually knows about sales and marketing in the twenty-first century.” Its revenue doubled to GBP 256.6m while its net profit jumped five-fold from GBP 12.3m in 2015 to GBP 65.8m in 2019. This is a testament of the fans’ loyalty towards Warhammer. Few companies can not only keep their customers after years of mistreatment but also win them back with one big gesture.

So why are fans so loyal to Warhammer? Warhammer has a differentiated customer experience that few can match – beautifully designed miniatures with great details, a strong physical network of players, and cleverly crafted fantasy worlds that fans can immerse themselves into. Even as fans complained about GW during 2010 – 2015, they acknowledged GW’s miniature as best in the industry. GW has the unique competence to mass-produce high-quality miniatures in a cost-effective manner because it has years of accumulated manufacturing know-how and the scale to internalise its entire manufacturing process. As the largest fantasy miniature producer, they can cover the fixed cost of investing in customised tools and mouldings. The design team can work closely together with the manufacturing team to push the limits on manufacturing the next best miniatures.

Gamers are going to play the games that have a decent chance of finding another Gamer to play against in the local community; thus it is critical to have a minimum player population size locally. Hence, GW uses its fleet of 500+ physical retail stores to provide physical space for local fans to meet and recruit new blood into local Warhammer communities. Local Warhammer clubs are formed as the fan base grew. It took GW over 30 years to build this physical network of Gamers globally which new competitors will find it hard to replicate.

Put in another way, GW’s moat lies in its physical social network of Gamers. Warhammer – the game – is the equivalent of Facebook – the digital platform – that binds these players together. Each new player joining Warhammer strengthens the social network because it increases the existing players’ probability of finding a good game quickly. Physical social networks are of course inferior to virtual social networks because 1) Gamers cannot have a game whenever and wherever they want, 2) Gamers’ social relationships are not digitalised and hence not accessible to GW, and 3) Gamers’ interactions cannot be stored in a useful format. Nonetheless, the physical social network is still a powerful moat for the business.

Finally, GW’s IP elevates Warhammer above other board games and tabletop games. Most board / tabletop games are hit-driven businesses where new gameplays are easily copied by competitors. Unlike most board / tabletop games, Warhammer fans immerse themselves in the narratives as they collect and play the miniatures. It is a common scene to see Warhammers fans tries re-enact plots from the narratives through the games. Ask any Warhammer fan what they like most about their favourite miniatures, and the reasons usually are the characters’ personalities and their struggles and victories in the narratives. The progress in the narratives will introduce new characters which then is made into new miniatures. The stories give meanings to the lifeless miniatures and emotional bonds are formed when fans project themselves into the characters. This emotional bond with Warhammer drives repeat purchase. Or in the modern business parlance, Warhammer fans have high lifetime value. This strategy is common among other successful media franchises such as Pokémon and Star Wars.

I believe GW’s moat is likely to grow stronger with its unique corporate culture and first-rate management team. GW’s culture is formed by employees who are themselves biggest fans of Warhammer and they come to work here because they love what they do. GW also has a very strong creative culture where people have the creative freedom to try new things. After spending two decades at GW, Kevin, the CEO, is the right steward of company culture. I have come to know him better over the last year. He cares deeply about Games Workshop and he understands the full potential of Warhammer IP. Kevin set up a new media business unit to bring the Warhammer IP into mainstream media. If this is done successfully, the acquisition cost of new fans is going to decrease significantly. One of the biggest investment risks is Kevin’s departure due to some unforeseen reasons.

I value GW in two parts – core earnings from the sale of miniatures and royalty income from IP licensing. Through acquiring new fans and growing spend by existing fans, GW can grow its core earnings by 10-15% annually. I do not need to know precisely the size of the total market to believe that GW has a very long growth runway ahead. Another popular card game called Magic the Gathering has ~ USD 500m in revenue double that of Games Workshop’s revenue. GW has a sizable fan base in China but negligible revenue. I think China can be at least as big as the US which is GBP 100+m (50% of total revenue). On the royalty income side, GW is significantly underearning relative to the strength of its Warhammer IP. It is currently generating GBP 11.4m which is only 5% of its miniature sales. The top media franchises, such as Pokemon and Dragon Ball, make the majority of their income from licensing rather than merchandise sales. Despite paying a hefty multiple of 24x 2020 earnings, I believe we are getting a fantastic bargain because this is a very high-quality franchise with strong growth prospects, under-appreciated IP monetisation potential and strong corporate culture that reinforces its moat with time.

Notes on IBKR’s November results and Peterffy at the ’18 Goldman Sachs conference

Disclosure: both a happy investor and client of Interactive Brokers.

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It is a well-known human bias to neglect large absolute trading commissions because we look at them relatively to the even bigger amount of money we invest. I am a big believer in minimizing any friction in the investment process (trading less which lessens commissions and frees up time to think long term; paying less for trades by being an IBKR client, although the cheapness creates a “casino effect” of wanting to trade more frequently).

Intro

We will cover IBKR’s November month results that were released this week. Founder Mr. Peterffy had interesting comments about them on the Goldman Sachs 2018 conference that took place yesterday.

First I’ll explain how I go about thinking about the IBKR’s monthly metrics in general.

Executive summary

  • most important monthly KPI to track: user account growth (it drives LT equity growth which is IBKR’s most important value driver)
  • November user account growth was “disappointing”, yet still in line with the last 10 year historical pace of 18% CAGR. The disappointment was driven by China curbing remittances to stellar grower – and intro broker to IBKR – Tiger Brokers
  • IBKR will start paying interest on smaller accounts
  • Israel markets will be added to IBKR
  • important question for the thesis: will exchange volumes keep on losing share to internalizers?

Let’s get started…

IBKR’s monthly metrics mental model*

*Hate using this snobby term but it made for the shortest title.

Although equity growth is the value driver for IB going forward (driving interest income) , account growth is the most useful reported number to gauge future LT equity growth, as

  • monthly equity growth numbers are affected by short term stock market movements
  • equity growth lags account growth because people only start depositing large chunks of money into their account once they are familiar with the platform (i.e. half of end-of-first-12-months money only arrives after >6 months)

Commission growth is also very noisy ( ~f(volatility)) and only 1/3rd of earnings.

In short, closely track MoM account growth to know if IB is on pace for LT equity growth.

Account growth + (ST NOISY= Clients adding deposits + asset inflation) = LT Equity growth

So I observe account growth and know that (ST NOISY) was historically 10% and should be at least 4% on avg. going forward, i.e. observed account growth + 4% =  conservative LT equity growth.

Let’s discuss the latest results and the interesting conference.

November numbers & Peterffy on the GS Conference

  • On the November numbers, IB swung up 8% intraday & ended slightly down on the day
  • I agree with the directional close-to-closing price given the numbers
    • Short-term value driver commissions were great (market volatility) while
    • accounts growth disappointed at +1.3% MoM (vs huge growth last months of course, even the annualized disappointing MoM pace is still 17%, +- on par with the 10-year CAGR of 18%)
      • Peterffy revealed on the GS conference that MoM account growth was affected by special measures by Chinese govt that constrained mainland Chinese customers to deposit money into their Beijing-based intro-broker Tiger Broker app accounts (i.e. IB bank accounts in Hong Kong). Probable reason: Yuan is under pressure and growing money outflows put further pressure on Yuan
        • Tiger Brokers grew at a stellar rate last years (now processing >200BUSD in trading volume p.a.) & has a great app with local support, advertising and investors in the mainland (the Robinhood of China but with a smarter client base as unsophisticated Chinese retail investors are not interested in global investing) but back-end of the app is 100% IBKR and the bank account is with IBKR HK
        • My take: a yuan devaluation event should be positive as the restraint can be more easily lifted afterwards & as more Chinese would consider investing outside China after a deval

Notwithstanding current market correction, IB’s LT equity growth (main value driver) should be at least 4% p.a. above account growth as clients deposit more money into their existing accounts and asset prices rise in long haul. In fact, historically the equity CAGR was 10 %-points above account CAGR. As interest rates rise and IB pays even more interest on client cash than competition, there is no reason the pace of client deposits should slow so 4% seems very conservative.

Even annualizing these disappointing MoM numbers gives us 17% account growth or in my view 21% conservative LT client equity growth, which is still 2 pp above my model of LT equity growth at 19%.

Recent additions to the platform Peterffy discussed:

  • Israel markets (next week)
  • New screening functions for IB’s bond platform (direct electronic access)
  • IB features in recent past makes them more & more of a bank:  IB is now considering getting banking license abroad & US. In US, broker-dealers can do almost anything but  limitations abroad are generally more extensive
  • Effective 1st of Jan IB will start paying interest for small clients with total equity lower than 100k (previously 0%). The rate these clients will get will be linearly ramping from 0% to benchmark minus 0.5% with account size from 0 to 100k, e.g. 60k client would get 60%*(bench-0.5%) on his cash

Recent SEC action on the payment for order flow “PFOF” competitor broker’s practice

  • Competitors burdened with more disclosure requirements to clients

Peterffy voiced his concern that brokers who’re accepting PFOF (the vast majority) are routing their orders increasingly to “internalizers” that execute customer orders against their private “parallel” market (e.g.  HFT arm of Citadel, public firm Virtu Financial):

  • This means less and less retail orders are going to the exchanges
    • Because retail orders are the lifeblood of market makers as they are viewed as profitable “noise”, there’s less incentive for market makers to provide liquidity-adding orders limit orders to the exchanges
  • thinks the decreasing real liquidity on exchanges is a “disaster waiting to happen”

I read the Virtu Financial prospectus, and the story is not that simple it seems: exchanges are monopolies and they have been inflating their commissions and data fees over the last years at higher than inflation. IBKR IR themselves complained about that to me when I asked about that cost item. Customers using internalizers save exchange fees that could theoretically be shared amongst client, broker and internalizer. In practice however, this windfall (and slightly worse execution when using an internalizer) goes to internalizer and broker. I still think the internalizer model is a threat to IB’s 100% direct-exchange model as this ongoing exchange trading substitution may continue. This is mitigated by IB’s tiny market share that can grow much bigger in 3 or 4 out of 5 client types (prop shops is saturated &  sophisticated individuals is saturated but only in the US).

Somewhat distressing is Peterffy exaggerating JPMorgan’s new “free trading app” clients being patsies:

Well, obviously, businesses have to make a profit or at least break even. So one day advertise no commissions. They may have to make it up somehow, and so that is partly in selling the orders, partly not paying interest on the deposits, partly charging higher margin rates. I understand that Robinhood does this, and that’s okay. But to the extent JPMorgan is doing this, I think it’s a big mistake. People don’t like to be taken for a patsy, and it’s going to be — they will regret this, I think.

There are huge differences among brokers how much they take as PFOF as they negotiate how good the client execution should be. Fidelity and Schwab have ~10x better price execution than RobinHood and earn less from PFOF. As stated above, theoretically PFOF could be compatible with great execution as exchange fees are saved.  The difference between IB’s price execution and the more established brokers is really a few basis points (insignificant for individuals), while for Robinhood it’s >20bp.

Growth

Interesting point was that not only Asian intro broker clients are growing fast. A lot of European private banks are becoming intro brokers too as they can’t keep up technologically.

TC

Dart Group – Memo post FY17 results

Thomas’s enthusiasm on religiously updating this blog has put me to shame and as such I will share my latest thoughts on Dart post the latest results release last week.

While many investors counsel against sharing investment ideas because it exposes one to commitment bias. Despite the commitment bias risk, I want to document my thoughts ex-ante so that I can remove any hindsight bias should my judgement prove to be wealth destructive. So here we go:

Post the results, DTG share price went on free fall – a whooping 20% drop in 2 days. Just like TC, DTG makes up ~25% of my portfolio. So this was emotionally hard to bear despite all the lessons of rationality that we keep reading about in books.

The market reacted violently because:

  • Operating profit probably did not meet market expectations given the run-up in share price before the results release
  • Huge uncertainty associated with the non-UK ownership issue

I suspect the issue surrounding non-UK ownership was the more important driver is pushing the share price down. As we all know, market hates and punishes uncertainty very punitively.

From an operational perspective, I was very happy with the progress that DTG is making for couple of reasons:

  • The capex numbers confirmed a previous assumption that DTG has ~50% discount on the listing price of the new Boeing 737-800s
  • Revenue growth in winter season continued which is critical as the newer fleet would have to be justified by better utilization rate all year round
  • Advanced revenue jumped 40% YoY which is STRONG indicator of the success of the new bases – Stansted and Birmingham
  • Net debt was very much under control helped by the cash flow generated by negative working capital with growth

The main reason for softer EBIT margin was due to one-off costs and cost ramp up in new airports (Stansted and Birmingham) i.e. the cost was incurred before the revenue came in.

When we decided to invest in DTG in Oct 2016, the biggest risk was that Brexit would lead to a sharp drop in demand for oversea package holidays which would be disastrous for DTG as it was taking on debt to purchase new aircraft. Increasing capacity through debt when demand is about to decline is a recipe for massive value destruction as witnessed in many of the commodity companies.

However the strong advanced sales and the revenue growth in FY17 indicated that the demand for package holiday in the UK has not been affected by the weaker Sterling post Brexit. This corroborates the UK holiday data released by ONS in May 2017. The strong growth in advanced sales is an important signal because it implies that people are booking their summer holidays as usual. In fact the strong demand for FY 2017 summer is particularly encouraging because Britons would have fully digested the impacts of Brexit and still decided to spend on holiday in the subsequent year.

The implication of the above point is that our worst-case scenario is increasingly unlikely to happen and as such the downside risk of an investment in DTG is diminishing. Operationally, the range of outcomes for DTG in the next 2 years is heavily skewed to the base and bull case. (Base case assumed growth associated opening 2 new bases and no growth afterwards and bull case assumes that there is still 5% organic growth in topline after the new bases are up and running at steady state)

Going forward, I think the value of DTG is driven by the following factors:

  1. Normalized run-rate FCF in base case in GBP 120 – 140m which implies an FCF yield of 17% based on the share price today
  2. Pay down of debt will lead to appreciation of equity value
  3. Given a mix of old and new aircraft in the fleet today, DTG can choose to retire old planes more quickly depending on the demand conditions. Full credit to TC for his insight on this point
  4. Multiple expansion as the company proves its success with the new bases and lower leverage in the steady state environment

As such I have added and will continue to add to my DTG position if the price goes down further in the absence of new information.

On the non-UK ownership point, the context is such that both EU and UK requires their airlines to be majority owned by EU or UK nationals. Before Brexit, UK airlines just have to comply with the EU regulations. Post Brexit, UK airlines have to ensure that the company is majority UK owned to maintain its operating license. DTG is proposing to add a new clause to the article of association to force any non-UK shareholders to sell his/her shares. Ryanair and Easyjet already have this clause in their article of association. The worst case is that we are forced to sell when the share price is very low as we are not UK nationals.

Firstly, DTG noted in its announcement that they believe currently non-UK shareholders make up less than 35% of the shareholder base. DTG is 40% owned by its founder, Philip Meeson who is a UK national. Secondly, the company will try its best to avoid activating such clause unless absolutely required. Thirdly, we still dont know how the Brexit negotiation will play out on this issue – maybe it is favorable maybe it is not.

So there is a good chance that this clause is not required. But the important question is if the company decided to trigger this clause how are they going to decide which shareholders to force sell. I.e. if there are 40% non-UK shareholders and DTG wants to bring that down to 35%. How do they choose which 5% of the non-UK shareholder base to force sell?

The company did not comment on this. But we decided to look at Ryanair and Easyjet for inspiration. It turns out that it depends on the chronological order at which non-UK shareholders register their shares with the company. For example, if you are the first non-UK shareholder to register with the company then you are the last one to be forced to sell. And they will first force sell the shareholders who have not registered with the company. So this gave me great comfort that as long as I register my shares with DTG asap, I should be okay.

So I am comfortable with the two issues and continue to hold the DTG shares. Of course I change my mind when the facts change to quote John Maynard Keynes.

MC

Notes on package holidays

We recently took an interest in the business Dart Group plc “DTG”.

My notes on the Package Holiday industry, as the high growing segment of DTG is Jet2holidays:

  • Necessary adjustments – the package holiday industry suffered as new tech competition (e.g. Booking, Expedia and later Airbnb) grew offering customers more choice:
    • Assimilation – One key advantage of online competitors for customers is customization (exact holiday length, start/end date, type of hotel room). The industry adjusted by offering more choice.
    • Consolidation & bankruptcies – TUI and Thomas Cook have increased their market share since the financial crisis. Size has brought some two-sided power on price.
    • Control – Recent strategy has been to increase control over customer experience by expanding assets on the balance sheet (hotels, planes). Large package holiday firms might scoop up a low-cost airline like DTG to increase control. Note: Jet2Holidays is very focused on customer experience (e.g. see news on unique resort check-in).
    • Differentiation – package holidays to remote places where booking websites are not as penetrated yet (First Choice’s strategy as early as 2005). A move away from commoditised package holidays boosts margins. In 2012, 3/4th and 2/3rd of TUI’s Nordic and British customers respectively booked such highly tailored holidays (2/3rd of German customers was “still” buying mass-market packages).
  • Renaissance – In part because of these adjustments, there has been a renaissance since ’08. Mintel forecasts a further 10% rise in demand by 2020. As of 2016 however, total package holiday demand is down 25% since its peak in the early 2000’s.

 

On all-inclusive package holidays:

  • value proposition
    • being spoiled by free lunches
    • peace of mind
      • holiday sorted out
      • no unexpected expenses
      • being looked after if holiday goes wrong (e.g. terrorism)
  • Growth  all-inclusive grew from 8% of worldwide holidays to 12% in the period ’10 – ’13 (PhoCusWright via Economist)

 

One last remark: Booking/Expedia/Airbnb charge quite high commissions (10-20%). This offers leeway for existence to others. It could also be a risk down the road if these commissions fell.

Notes on the European airline industry might follow.

 

 

References

A history of package holidays – Independent

A new package  – Economist

Tour operators are down but not out – Economist

Horrible holidays – Economist

Travelling on the same ticket – Economist

The return of the free lunch – Economist

From satanic mills to sundecks – Economist

Tour operators are down but not out – Economist

Thomson and First Choice to merge – FT.com

Different Towels – FT.com

Travel groups brace for holiday booking decline – FT.com

Tui to sell Hotelbeds Group for €1.2Bn – FT.com

 

SABMiller – AB Inbev deal

This week the Inbev offer for SABMiller shareholders closes.

While SABMiller trades at 45 pounds, i.e. the cash offer consideration, there’s also a partial share offer option that has become more interesting after Brexit currency volatility. By electing the partial share offer, one gets future Brussels listed Inbev shares with a five year lockup, and a small sum of cash upfront. Have a look at this great company presentation for background.

I imagine that the lockup clause is to discourage as many non-family holders of SABMiller as possible of taking this sweeter option and pay less for a successful merger. AB Inbev management is notorious for being frugal. If you are a real long term investor, this is true time arbitrage to take advantage of.

I made a Google Excel sheet with live updated prices to analyze the economics of this offer.

What I found is a pre-tax IRR (as of Oct. 4th) of 2.8% p.a. above the return one gets by just holding AB Inbev (ABI in Brussels) in the same period.

This positive carry is created by

1) paying only 80c on the dollar for ABI restricted stock,

2)  getting the extra dividend on this incremental 20c of ABI stock.

A 25% dividend tax subtracts less than 10 basis points p.a.

I am still hesitant to participate. On the one hand I am a big fan of these large positive carries. On the other hand I have doubts about the valuation of public mega-cap companies today. This brings me to very interesting letters of the hedge fund Horizon Kinetics about the unsustainable index ETF boom (see here here and here)

Because my portfolio is not levered at all (I am about 90% invested, and 10% in cash), there is room to participate and hedge my exposure by shorting AB Inbev as the short borrowing cost is zero. As my restricted stock is unlisted, this can only be done at a small percentage of my portfolio to avoid margin call mayhem in case Inbev stock rallies heavily.

If I participate and hedge my exposure, it will most probably be at a percentage of NAV < 5%.

Best,

TC

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