4Q 2017 Quarterly Letter – America’s Greatest Export

2017 was an extraordinary year in the financial markets. For the first time on record, the S&P 500 Index delivered a positive gain in every month of the year. The S&P 500 and Russell 2000 indices finished the year up 22% and 13% respectively, while also experiencing the lowest level of volatility in history with the largest peak-to-trough drawdown on the S&P 500 of just 2.8%. The best performing area was large-cap technology companies while the smaller Russell 2000 Value index, consisting of many small financial and energy companies, gained just 8%.

The market advance was partially due to the anticipation and ultimate passage of tax reform, which lowered the corporate tax rate from 35% to 21% and cut federal income tax bracket rates across the board. While the corporate tax cut temporary boosts after-tax profitability, we believe it may not have the full benefit most investors expect. The free market ultimately sets profitability and thus it will likely revert to historical averages as competition causes prices to fall and wages and other costs to rise. As an example, we met with a utility that immediately has to give 100% of their increased profitability back to their customers in the form of lower prices per their agreement with the regulators.

While market momentum is strong, we are increasingly concerned about excessive optimism. The Investors Intelligence and American Association of Individuals Investors (AAII) polls both showed 60% of investors are bullish vs. 15% bearish readings, a measure in the top 1% of all-time optimism. During periods of such high sentiment, the S&P 500 Index has historically returned half its historical average in the following year.

Speaking of investor optimism, a few clients have inquired about Bitcoin and other cryptocurrencies. Some people believe that a finite, digital, decentralized currency acting outside the traditional banking system using a blockchain database could be the future of monetary exchange. The bullish case for bitcoin is that if Bitcoin became the new global currency and attained the value of the entire $7.4 trillion gold market, with only 21m Bitcoins in circulation, each Bitcoin would be worth $350,000 compared to just $15,000 today. More likely, most cryptocurrencies will be worth zero (there are more than 1000 different cryptocurrencies). The market value of Bitcoin is $250 billion today. All the cryptocurrencies put together have a market capitalization of $725 billion. To put that into perspective that is roughly 10% of the value of all the gold in the world. Given that we at Eidelman Virant Capital focus on investing in assets with tangible asset values (real estate, machinery, cash), steady streams of cash flows, and trading on liquid global exchanges, we don’t plan to direct client assets into cryptocurrencies.

We do continue to find attractive specific individual investment ideas including some content media companies. With the internet enabling viewing at any time, on any device, without costly bundles, annoying advertisements, and restrictive time slots, we see quality content companies ideally positioned. As the industry scrambles to consolidate, we see content companies like Time Warner (TWX) and Lionsgate Entertainment (LGF.B) most likely to benefit financially and ultimately be acquired.

When I discuss our media-themed investments, it’s impossible not to thank and acknowledge the help from friend and fellow fund manager Ben Weiss. Ben graduated from Vanderbilt University and Washington University Law School and worked as a corporate lawyer in St. Louis and as an equity analyst at ADW capital, a deep value NY-based hedge fund. In 2014, Ben founded 8th & Jackson Partners, his own concentrated value-oriented hedge fund focusing on media companies. Ben is also a guest contributor on the media industry to Hollywood trade publications like Variety and Hollywood Reporter. As a consultant to Eidelman Virant over the past year or so, Ben’s expertise in media as well as other areas has proved invaluable to our research efforts.

Our investment team is excited as we enter 2018. With nearly 50% of all investment dollars now using passive exchange-traded-funds (ETFs), we are finding less analysts covering individual stocks and more inefficiencies in the market which can increase our chances of earning superior risk adjusted returns going forward. In particular, we think qualitative factors such as management cultures that empower employees and make raving fans out of customers are not being fully appreciated by ETFs and quantitative funds. We are confident such market dynamics, in addition to our adherence to value investing principles, will continue to help clients achieve their investment goals.

America’s Greatest Export

Twenty years ago while living in France on a foreign exchange program, I remember turning on the TV and being surprised by how many TV stations were filled with American shows either dubbed over or with French subtitles. I later found out the movie theatres were filled with the latest Hollywood releases and discotheques were blasting American techno music. Why is American entertainment so prevalent all around the world? Actor Matthew McConaughey said it best: “Hollywood is America’s greatest export.” America’s culture of freedom of expression, risk taking, and protection of intellectual property (IP), combined with ample venture capital and talent, creates entertainment that is the envy of the world.

Good Businesses

U.S. Entertainment companies enjoy many of the attributes we look for including high barriers to entry, libraries of valuable intellectual property (IP), recurring and non-cyclical revenues, heavy insider ownership, and high returns on capital. Conversely, media producers in other countries face censorship and even risk imprisonment for spreading certain ideas. Should they overcome the odds and succeed, they could see their valuable intellectual property (IP) copied without enforcement. With such global dominance, U.S. media stocks have delivered returns above the broader S&P 500 Index over the past 30 years and we believe these advantages will persist into the future.

Global Distribution makes Content King

Entertainment delivered directly through the internet to consumers anytime, anywhere, and on any device has changed industry dynamics. Companies with unique, high-value, globally recognized content no longer need to be bundled or even released into movie theatres. Many people are now “cord cutting,” a term used for cancelling traditional cable TV subscriptions and watching TV via the internet at a fraction of the cost via streaming services like Neflix, Amazon, Hulu, and Sling TV. These streaming services are growing rapidly and using operating cash flow to spend huge amounts on their own proprietary content in the race to create a fully integrated media company.

Benefits of Scale and the Consolidation Boom

The new model of creating and delivering content globally is leading to consolidation as many players don’t have the customers, content, delivery, or technology to compete. Leaders like Netflix have created a virtuous cycle where having more customers leads to more money to spend on creating better content which leads back to bringing in more customers. Other industry players are scrambling to catch up. Disney (DIS) recently announced a deal to acquire 20th Century Fox to give it more content to start its own streaming service. AT&T is trying to buy Time Warner to leverage its large customer base by adding CNN, HBO, and Warner Brothers Studios. The only independent production studio left to acquire is Lionsgate Entertainment (LGF), a company we own and outlined in the Q2 2017 letter. Recent consolidation strongly increases their scarcity value and likelihood of being acquired. In addition to Lionsgate, we believe the following companies are best positioned to achieve superior investment results due to the trends and changes occurring in the media industry.

Time Warner (TWX) – $91.50

Time Warner is one of the largest media companies in the world consisting of CNN, TNT, & TBS, Warner Brothers Studios (Batman, Superman, Looney Tunes, etc.), and HBO. As outlined earlier in the letter, we believe the proliferation of connectivity which enables content companies to directly deliver all over the world via the internet makes premium content creators more valuable than ever. In October 2016, AT&T announced it would acquire Time Warner (TWX) for $107.50 per share. This merger helps AT&T to create an offering to deliver premium content on every screen, anywhere. On November 8th, 2017, TWX shares dropped to $87 per share on news that the U.S. Department of Justice (DOJ) was suing to block the deal on anti-trust concerns. Many experts believe the DOJ doesn’t have a strong case as no vertical merger has been taken to court since Jimmy Carter was president and that case lost. We believe this deal will be resolved shortly after the March 2018 trial and TWX shares will appreciate to $107.50 when the deal is approved, a 17% premium to the current price in roughly six months. Should the deal not go through, we believe Time Warner is worth the buyout price of $107 on its own. TWX shares currently trade at just 14.7x 2017 estimates of $6.25 per share, a 20% discount to the valuation of competitors 21st Century Fox (FOXA) and Disney (DIS).

Dish Network – (DISH) – $47.75

While Dish is known for its direct satellite business with 11 million subscribers, the vast majority of the value in DISH shares are in its investments in wireless spectrum. Founded and 48% owned by Charlie Ergen, a bold and patient visionary, who has taken the cash generated from the satellite business and invested $21 billion in wireless spectrum licenses in the belief that 5G high speed wireless connectivity will generate tremendous innovation value in both consumer and industrial applications. While just thought of today as high-speed wireless connectivity for cellphones, high speed wireless 5G internet could be used for all new “internet-of-things” applications like driverless cars, drone delivery and a plethora of industrial applications that don’t exist today.

While it owns valuable spectrum, Dish does not have the capital to build out a full scale 5G network on its own. The clearest way to realize the value in this company is to sell to a company like Verizon (VZ) or Amazon (AMZN) or to partner and lease the spectrum. Like beachfront property, we believe Dish’s scarce and valuable spectrum operated by a successful owner with the entirety of his net worth invested alongside us creates a compelling investment.

Based on recent auction values and a conservative valuation on the satellite business, we estimate the wireless spectrum, satellite business, and sling TV business (another small, but valuable business) is worth roughly $90 per share, an 83% premium to the current price.

Disclosures

This post is for informational purposes only and does not constitute a complete description of our investment advisory services. This post is in no way a recommendation of any security or a solicitation or offer to sell investment advisory services. This newsletter should not be construed as advice to buy or sell any particular security. This post is not definitive investment advice and should not be relied on as such. It does not take into account any investors’ particular investment objectives, tax status, or investment horizon. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Any forward-looking statements speak only as of the date they are made, and Eidelman Virant Capital assumes no duty to and does not undertake to update forward-looking statements. Certain investments mentioned in this post may not have been held by clients of, or recommended by, Eidelman Virant Capital.   Past performance is not indicative of future results.    

Read the Q4 2017 Quarterly Letter