Rolls Royce and the Sequoia letter

At Bronte we have a large position in Rolls Royce - the UK based manufacturer of jet engines.

Rolls is a relatively simple story - Rolls is part of a duopoly in engines for wide-bodied aircraft (aircraft with two aisles like the Dreamliner, A350, A380, 777 and forthcoming 777X).

Jet engines cost a fortune to develop and are sold at a loss - but with huge out-year maintenance streams.

The maintenance is potentially very profitable. If you sell a lot of copies of the jet engine maintenance margins can get very fat.

This duopoly is almost impossible to break. Not only would a company need to spend billions of dollars before they developed a competitive engine they would then need to sell the engine at a loss for many years until the maintenance streams come on.

Moreover it is risky.

If you attach your engine to an unsuccessful plane (like say the A340) production will be a few hundred copies - and you will eat all those development costs for smaller maintenance streams and you will not get scale on maintenance. Making unsuccessful engines or attaching engines to unsuccessful planes is a good way to lose a lot of money.

Contra: if you attach your engine to a hit plane like the 777 - especially if it is the only engine choice for that plane - you will make thousands of copies of the engine and develop scale in maintenance. And that is profitable in the billions - and maybe even tens of billions of dollars range.

Rolls has had a few less than successful planes in recent years - let by the A340 but probably including the A380. (The super-jumbo is wondrously fuel inefficient.)

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The bull story revolves around the A350. On paper this new plane is the most fuel efficient long-haul plane in the world - and if that is true it should - over time - receive thousands of orders. (The current order book is slightly over 800.)

On paper Boeing's forthcoming 777X is a match for the A350 in fuel per seat kilometer - but that plane is still a paper plane. It has not flown yet.

Rolls Royce is the monopoly engine supplier to the A350. GE the monopoly on the 777X.

At Bronte we spent considerable time trying to work out whether the A350 was as fuel efficient as it was claimed to be. (Other planes, notably the A380, have not met spec.)

If the A350 meets spec and does not fail on safety then Airbus will sell many more than the current forward order book and Rolls will have a super-successful engine on its hands. Revenue will more than double over time. Operating margins will probably also double. Rolls Royce stock will be a big winner.

A test flight came through Sydney and we tried to get the fuel loading statistics from the airport. (No we are not kidding. Alas the plane was refueled by Virgin Australia and not Qantas. I could not get through.) We had other methods to try and assess the numbers too.

That question really comes down to carrying capacity. The A350-900 is claimed to be able to handle 314 passengers fully loaded. No plane has yet been fitted out with more than 300 seats but some are being delivered later this year with 306 seats.

If the plane is overweight (because it does not meet specifications) then it won't be able to carry that much load. In that case the airlines would need to spread the seats out. Passengers love this (more leg room) but airlines hate it. Fuel efficiency is compromised.

Alas the plane that came through Sydney was fitted out with about 260 seats - it was really spacious. This could have been because the plane was overweight - or it could have been because they wanted the plane to appear spacious as Airbus was merely drumming up orders. We could not tell.

--

We finally have a definitive answer. We have discussed the matter with pilots who have seen the training manual. That includes take-off weight specs and fuel specifications.

The plane is as good as its specifications.

And Rolls Royce should be a great stock.

This is old-fashioned in-the-weeds stock research.

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There is a bad bit to Rolls Royce though. It has a business in very big diesel engines - sometimes used on ships but even more pertinently used in the stabilizer motors of large oil platforms. All of this business looks pretty bad at the moment - the cycle looks bad - and the barriers to entry look far lower than the core jet engine business.

Moreover there is no A350 on the horizon - no world-beating product that should make lots and lots of money.

It is this business - and the seeming willingness of management to commit more capital to this business - that is the bear case for Rolls.

It is also really the reason why Rolls Royce stock is a bargain.

And I have never really heard a decent explanation of why Rolls has continued to commit capital here.

But now I am hearing the whispers of activism. The latest Sequoia letter is pleading for activism. To quote:

Rolls-Royce, our largest UK position, seems willing to destroy shareholder value in the name of diversification. Rolls-Royce has a world class business making engines for wide body jets. These engines are often sold at breakeven prices, or even a loss, but come with long-term Total Care service contracts that are quite profitable. Rolls shares a duopoly with General Electric Company (NYSE:GE) in wide body engines and the barriers to entry for any newcomer would be formidable. Not only is the business intensely regulated, but a new player selling jet engines without an installed base of profitable service contracts likely would lose billions of dollars to capture market share from GE and Rolls. Not surprisingly, Rolls earns more than a 20% return on invested capital in civil aviation and its installed base of service contracts and strong backlog suggest Rolls should grow profitably for years to come. 

And yet Rolls’ board of directors decided that it wanted to diversify deeper into the marine engine and power generation businesses, competitive sectors that are being encroached by low cost Asian players. To pursue this strategy, the board appears to have pushed out a sitting CEO who had crafted the successful Total Care service contract selling model, and replaced him with John Rishton, a board member who, in our meetings with him, has shown minimal awareness of the returns on capital his acquisitions have generated. 

Rolls’ stock declined more than 30% in sterling during the year as investors lost confidence in management. We held our shares in the belief that Rolls’ wounds are self-inflicted and reversible. The recent share price does not properly value the civil aviation business even if we ascribe little value to the marine and energy businesses. However, management and the board seem stubborn and entrenched, and it may take a tough-minded activist to force strategic change.

I am a little happier with John Rishton. The market hatred of the man has allowed us to buy Rolls cheap. But whatever - he has a little explaining to do or the activists will get rid of him kind of fast. If the whispers get to me they have really got around Wall Street. I am kind of low on the pecking order.




John

Herbalife and subpoenas

Bill Ackman has now conceded that his (sub)contractors have received subpoenas regarding Herbalife.

The Wall Street Journal - who broke the story say:

[the investigators are] looking into whether people, including some hired by Mr. Ackman, made false statements about Herbalife’s business model to regulators and others in order to spur investigations into the company and lower its stock price.

There is a presupposition here - which is that the Feds believe that the story told regulators is false.

No more comment is required.



John

A puzzle for the next ten days...

I am just about to get on a plane to China and Hong Kong - so I will be away for a little while.

However I have a puzzle for all you Herbalife junkies out there... and it might require you do some research.

Imagine you were the very first Herbalife distributor and you recruited three people and they - eventually and through their downline - recruited the millions of people who now consume and/or distribute Herbalife.

And also presume you did nothing else for the rest of your career. You just sat there and collected the "recruitment rewards" or the "royalty checks".

Roughly how big would your income be now? And from how many levels would you be collecting your income?

Answers either by replies to this post or by email.





John

An interpretation of the Herbalife result

The Herbalife result had three elements - two bad, one good.

The bad elements are

(a). That volume fell - and quite sharply - minus 6 percent, and

(b). There was an inventory build in the face of the volume fall.

The shorts have played these elements up - and combined they meant that the cash flow was sequentially far less good.

The good element (which the company played up) was

(c). distributor numbers and retention went up sharply.

In the past distributor numbers and volume have been very tightly correlated.

They are no longer tightly correlated.

Inevitably they will become correlated again - but the question is which direction. Will volume growth rise to match distributor growth or will distributors leave disillusioned?

On this the Herbalife debate will hinge. [The bears will argue the FTC will also be an issue - but I doubt that strongly.]

An interpretation of the results in the light of Herbalife corporate rule changes

The company implemented three core rule changes which were trialled first in Eastern Europe and which I have cross checked with some Eastern European distributors.

These are

i). Requiring that you qualify as a distributor slowly - ie there are no 4000 point success builder orders any more. Note that this rule change slows orders down.

ii). Requiring that the first qualification not be by "field sales" - you must buy from the company (note this slows orders down in Mexico and other countries for reasons that will be seen below).

iii). Requiring that if you sell via a website you do it under your distributor label (you get paid) on the GoHerbalife.com site. A delivery is then made direct to the customer obviating the need for the distributor to hold any inventory - and hence allowing de-stocking of distributor inventory and thus slowing current sales.

Why these rule changes

There are several reasons they implemented these rules.

One reason is that if a distributor qualifies as say 4*$1000 orders she is more likely to stay around than a distributor qualifying by a single $4000 order. The upline can then focus training on distributors who are more likely to stick around. This means new distributors become more effective.

A second (and possibly more important reason) is that they are very good at fending off Ackman's complaints. Slowing initial orders is antithetical to inventory loading (and inventory loading a required component of declaring Herbalife a pyramid). More importantly the third rule change obviates the need for any distributor inventory - and is a complete protection against a claim that Herbalife is a pyramid.

A third reason is about control of the business - particularly in developing markets. For example, in Mexico the up-line distributors have built warehouses all over the country - there are three Chairmans Club members who own the warehouses. The Chairmans club members can distribute Herbalife to you same day anywhere in the country almost everywhere - even with crappy Mexican logistics.

This is good for Herbalife (as they get lots of sales) but they are a risk for Herbalife - in that the Chairman club members might defect to a competitor taking their warehouses, customers and downline with them.

To "own" the customers Herbalife wants distributors to qualify with sales direct from the company. They are banning "field sales" for qualification.

Moreover Herbalife is building its own warehouses over the country. As it does this its distributor warehouses are being (to a small extent) de-stocked and its own warehouses are being stocked. The de-stocking of distributor warehouse is a drain on current sales and the stocking of its own is a costly inventory build.

All of these things should (i) make Herbalife stronger and (ii) explain the falling sales, increasing inventory and simultaneously increasing distributor numbers.

And if this interpretation is correct Herbalife should come back growing volume with a vengeance.

This is a deferred growth story.





John

Maximus and outsourced unemployment services in Australia

Maximus (NYSE:MMS) is a large cap and highly valued government outsourcing company based in Reston Virginia (outer suburban Washington). Its second biggest market by revenue is Australia (and I think by the amount of cash trapped in Australia in presumably depreciating Australian dollars the Australian arm has been particularly profitable).*

The stock chart is - well - ballistic. This is a market favourite:

Here is the revenue split from the last Form 10K.

  We operate primarily in the United States, Australia, Canada, the United Kingdom and Saudi Arabia.

        Our revenue was distributed as follows (in thousands):

		Year ended September 30,
		2014			2013			2012
United States		$	1,306,026		$	999,419		$	775,871
Australia			170,727			157,383			163,482
Rest of World			224,159			174,477			110,792
​	​	​	​	​	​	​	​	​	​	​
Total		$	1,700,912		$	1,331,279		$	1,050,145
​	​	​	​	​	​	​	​	​	​	​
​	​	​	​	​	​	​	​	​	​	​

The Australian revenue is from a government outsourced employment agency business. 

To get welfare payments in Australia you need to be actively looking for work (and sometimes need to appear at minimal job-readiness courses and the like). Until 17 years ago the government had a large bureaucracy (The Commonwealth Employment Service) who administered this.

The CES was effectively privatised with private sector organisations (and sometimes charities such as the Salvation Army) taking this function. The function included sometimes kicking welfare recipients off welfare (something that made the business difficult for some charities).

Last night the Australian Broadcasting Commission (the Australian equivalent of the BBC) aired a program on how this program is working. This was done on "4 Corners" which is far-and-away the lead current affairs program in Australia.

It was not pretty. 

To quote:

"There are credible claims of widespread rorting by some agencies.... we have now completed an investigation which suggest that significant fraud, criminality is going on."

Later it suggested that only 40 percent of the fees paid to agencies were against verifiable activities. The widespread practice of falsifying signatures, falsifying job interviews that unemployed people attended and falsifying disabilities of the unemployed was exposed. [For example an agency collected larger fees for working with more "disabled" people so there was a tendency to suggest people had mental illnesses or the like. More regularly signatures were faked using cut-and-paste methods to show unemployed people attending interviews that they did not attend or training courses that they did not attend and hence to rort fees from the Government.]

The number one target of 4 Corners was a domestically owned organisation called ORS. The evidence (if true) was utterly scathing.

Max Solutions - the Australian business of Maximus - was the second biggest target - but to be fair the claims made against them were far less scathing. Still they alleged that Max was directing unemployed to fictional training programs owned by Maximus and hence rorting the government. For instance they suggested that Max Solutions had enrolled 115 people in a training program in a room that could physically only take 15 people. [They were presumably - although this is not stated - faking attendance or even enrolment records or else they would not have got paid for these services.]

You can find the story (including a video replay) here. 

All of this is going to be deeply problematic for Maximus though. As the last 10-K disclosed:

We are currently in the process of rebidding on much of our work in Australia. We anticipate that a new contract will commence during the fourth quarter of fiscal year 2015. These contracts are likely to have more contingent revenue streams, less up-front fees and will likely incur losses in early quarters. However, we anticipate that the contracts will be profitable.

It isn't much fun to face such accusations by the National Broadcaster as you are rebidding all your contracts.

John

*$220 million in cash is held in currencies other than the USD. Given the Australian dollar has been very weak that hasn't been particularly nice.

The epic Retrophin 8-K filing

Martin Shkreli was formerly a biotech short-seller. I know those people. I am one.

They have their eye out for the inflated claim re the efficacy of a drug and the wheeling and dealing in stock.

Unusually Martin became CEO of a biotech (Retrophin) and became a wheeler-and-dealer himself. Martin also kept a twitter account where he recommended Retrophin stock and suggested (often correctly) that other biotechs were worth shorting.

He is a 31 year old - but all the photos make him look 17. The joke about his hyperactive twitter account was that he would tweet if he had a date.

Anyway eventually - and after a saga you can look up if you want - he was ousted as CEO of his own company.

Today the company released an 8-K explaining what the board found after his ouster - and it is already being described as an epic. Here goes for some of it.

Consulting Agreements. Between September 2013 and March 2014, the Company entered into several consulting agreements and releases with individuals or entities that had been investors in investment funds previously managed by Mr. Shkreli (the “MSMB Entities”), or that otherwise had financial dealings with Mr. Shkreli. The agreements provided for the issuance of a total of 612,500 shares of common stock of the Company, and a total of $400,000 in cash payments by the Company. The Oversight Committee concluded that the Company should not continue to treat these agreements as consulting agreements because their predominant purpose appears to have been to settle and release claims against the MSMB Entities or Mr. Shkreli personally, and not to provide meaningful and sustained consulting services to the Company.

And

Litigation Settlements. In the second quarter of 2014, the Company settled two lawsuits involving individuals who had formerly performed services for both the Company and the MSMB Entities. The Oversight Committee concluded that approximately $200,000 in cash payments made by the Company as part of these settlements appear to have been made to cause these individuals to transfer 176,388 shares of the Company’s common stock directly to Mr. Shkreli.

Read the whole lot here... 

[http://www.sec.gov/Archives/edgar/data/1438533/000119312515056286/d877873d8k.htm]

John

Disclosure - dumb luck I shorted a little recently. I just figured when he was fired at CEO we were going to find out more. And more.

But the really dumb luck. I got sick, missed the rise when he left, and only read he resigned today - so so only shorted today. I would rather be lucky than good.

Stock research on Spark Networks (jdate.com)

We are having one of our irregular looks into Spark Networks - the owner of the profitable J-Date dating site (and the unprofitable "Christian Mingles"). J-Date is a Jewish match-making institution.

One step of course is to get the young (and conveniently Jewish) intern to sign up and research possible dates. 

There is not that much activity (especially in Sydney) and some profiles are difficult. My favourite:

My personality is best described as high maintenance.

Seeking advice but J-Date doesn't look like it has much traction with the young (although its proponents argue it is a marriage site and hence of interest to people older than our intern and competes less than brutally with Tinder). 

Whatever: anyone want a high maintenance wife?



John

Mr Andy Z. Fan is better than you

This is possibly the finest biography ever submitted to the SEC. [You can find the original here.]

Background of Mr. Andy Z. Fan:

Mr. Andy Fan is a prominent Chinese-American businessman with outstanding connections with the Chinese government, long standing relationships with Chinese media, and has a strong fan base in China where he has appeared in various forms of media over the past few years. He was once the interpreter for China's Head of State -- Prime Minister Li Peng. Later, he was awarded a full scholarship to study on the graduate level in the U.S., and was introduced to former U.S. President Bill Clinton by the University President and served as Clinton's Chinese interpreter.   Mr. Andy Fan's popular book "Clinton and My Life" has made him an idol to millions of Chinese students, and a well-respected sought-after public speaker.

Mr. Fan is currently President, Director, and Chairman of the Board of AF Ocean Investment Management Company [OTCBB:AFAN].  AF Ocean’s mission is to help Wall Street investors identify and work with respectable and reputable Chinese counterparts and companies and assist Chinese corporations to understand that the only way to benefit from the world’s biggest capital market is through strict and consistent adherence to the rules and regulations that govern companies listed on American stock exchanges.

His nine popular books in China, including the No. 1 best seller in China in June 2011, also make him a frequent guest on TV, as well as being followed and interviewed by media everywhere he goes. He has been on numerous magazine covers, including “Chinese Business Leader”, “China Celebrity”, “China Private Capital”, “World Chinese Businessman”, “Discovery”, “Commerce”, “The View”, among others. To millions of fans and their parents across the country, Andy is their hero and a super star. Due to his popularity, he is often invited as the guest of honor and speaker by many prominent organizations, such as being invited to Nobel Laureates Beijing Forum and Forbes China City Investment Forum. In 2009, in celebration of the 60^th anniversary of the founding of the People’s Republic of China, Mr. Andy Fan was chosen to be one of “China’s 60 Role Models in 60 Years”, and his portrait was printed on a Chinese Postage Stamp that same year.

Dear Eurozone officials, Mr Putin is waiting

The FT has a remarkable story today about how Eurozone officials are worried about Greece. To quote:

" the fears of eurozone officials that the Greek government was unaware of the precariousness of its financial situation"

This is kind of amazing. There is an old adage - which is that if you owe someone $100 you have a problem. If you owe someone a $100,000,000,000 they have a problem.

Greece's debt (and hence the German/Eurozone problem) is somewhat larger than that.

Moreover Greece runs a primary budget surplus. The only reason the Greek government needs money (ever) is to roll existing debt.

If they default on existing debt that problem goes away.

Paul Krugman summarised the problem with devastating clarity.

Bluntly he points out the Troika (and the above worried Eurozone officials) can't hurt the Greek Government by denying incremental finance because the Greek Government does not need incremental finance.

--

Krugman does however point out that the Greek banks require finance. As Krugman puts it:

"the power of the creditors over Greece comes via the ability to crash the Greek banking system, which is heavily dependent on the ability to borrow at need from the ECB. Cut off that support, and Greece suffers banking collapse. So yes, the creditors have a large club they can use on a recalcitrant Greece."

But Krugman overstates that club. It is entirely within Alexis Tsipras's power to default to the ECB too. Indeed the pattern for government defaults is to simultaneously force a private sector default.

How about this for a negotiating position... we will pass a law to make it illegal for any Greek bank to repay the ECB. Period.

Then have a one week banking holiday, re-denominate all remaining Greek bank assets and liabilities in Drachma, and if a default event passes any court we will nationalise the Greek banks as-per-Washington Mutual - leaving the obligations in some stripped-down shell from which there is nothing to collect.

Finally, in this environment, depositors will receive shares in the new Greek banks in proportion to their deposits. Those shares will be worth a lot because an obscene amount of bank liabilities will be wiped out.

--

This will crash the Greek economy? You make me laugh. We are already at Great Depression levels and removing the burden of your silly debt schedules will be incredibly stimulative.

Sure we will lose access to clearing but Vladimir Putin is lending us a few billion dollars and we have a clearing arrangement in Singapore. [They will do this for anyone from Libyan dictators down...]

Moreover I was once told by Capital One - a respected US credit card company - that recently bankrupted people make the best credits.* After all their past debts have been cancelled and they are by definition solvent. It won't take two years and the financial markets will be happy to lend to us again.

--

Finally we are not a wildly interconnected economy. Its not like Finmeccanica - the Italian company which makes components for Boeing Dreamliners and thus needs the global financial and payments system to function. We do simple stuff, sell olive oil and feta cheese and lots of tourism services.

It won't take long but we expect our beaches to be overrun with fat often drunk German tourists. And we kind of like it that way. The fatter the better. At we will sell them Retsina. It will be cheap and they might learn to like it. You Germans like to drink, don't you.

--

So what do I want?

Enough money that I am allowed to run primary deficits. Fairly large ones. 1.5 percent of GDP would be nice but I will settle for 1 percent. And of course you know we are never going to repay it.

I don't care how you do this. You can do it as a direct subsidy, you can do it any way you like. But as we are not going to repay it so at some stage you are going to suck it up. For political purposes you probably want to dress it in some "equalisation scheme" so it is less obvious what you are doing. But that is your problem. You know what I want.

I am off to the hotel to read a little. Just kick back. Sunday night I have a flight booked to Moscow but I might go early. I hear the girls are hot there.

And besides Mr Putin is waiting.





Alexis...

*On a personal level I was truly told that by a Capital One senior staffer.

Bill Ackman is the Sabrina Rubin Erderly of anti-MLM campaigners

There is plenty of nasty stuff that happens on university campuses - so Sabrina Rubin Erderly wrote a story about a rape at University of Virginia that almost certainly did not happen.

She wrote it because she was ideologically committed to the idea that it did happen.

And in so doing she set back her own cause by a decade. 

--

There are plenty of abuses at multi-level marketing schemes. I have seen a few.

So Bill Ackman picks on what is probably the straightest MLM and bluntly makes up stories. In the first presentation Shane Dinneen (Ackman's staff member) got up and said that there may not be a single legitimate consumer of Herbalife products anywhere on the planet.

I promise you they are really easy to find. Daily consumers.

He did this after months of "research" which can only be like Sabrina Rubin Erderly's research - research to get your pre-determined opinion confirmed. Easily falsified research.

At some stage the anti-MLM campaigners will need to distance themselves from Bill Ackman's false research.

Sooner is better.

John