Dear Investor,
What a difference a quarter makes! In my year -end letter I bemoaned the fact that volatility had all but disappeared from the markets, and trillions had been invested in index funds with little regard to valuation. Much has changed in the first quarter of 2018, with market volatility returning with a vengeance and stock market indexes struggling to surpass January highs.
As you can see on your enclosed statement, we had a strong quarter in all of our portfolios. I believe the tide has turned, and you will see a shift in investor behavior with value stocks once again being in favor. It’s interesting that each of the high flying “FANG” stocks all the sudden are having issues. Apple for the first time is facing negative growth in worldwide smartphone sales. Google is facing European and American government concerns over their near monopoly with digital advertising. Amazon has been in the crosshairs of President Trump, and Facebook’s issues with customer privacy breaches will be a case study at Harvard Business School for years to come.
I have been sounding the alarm over market valuation for more than a year. I recently saw some new facts and figures that were eye opening. Over the past nine years the market has gained $25 T in value. That is five times greater than GDP growth, and twenty five times greater than the increase in profits. One of Warren Buffet’s favorite measurements of market valuation is total market value as a percentage of GDP. That ratio known as “The Buffet Indicator” was 140% this past January. The only time it has been higher was in 2000 when it reached 150%.
I continue to be concerned with the health of the American consumer. The personal savings rate has fallen to a very low 3%, and subprime auto loans and credit cards delinquencies have been rising. In 2017 for every $1.00 in incremental household spending, 90 cents was borrowed. Basically the average American family is stretching to maintain their standard of living. Offsetting this is a very strong job market, and hopefully wage gains can help reduce borrowing.
Although we find the market indexes top heavy and overpriced, our portfolios are full of great companies selling for very reasonable prices. The Trump administration continues to make the business climate very friendly with its ongoing efforts to reduce needless regulations and lower taxes. Our team is very optimistic about the prospects of the owner/manager led companies that we own.
In my year-end letter I discussed three potential “black swan” events that could disrupt markets. The threat of a war breaking out with North Korea seems to be off the table. The other two, war breaking out in the Middle East and China’s financial system imploding are still real possibilities. I have just finished reading a new book, China’s Great Wall of Debt by Dinny McMahon, and I now believe the situation in China is even worse than I feared. I believe the Chinese Communist party recently gave President Xi Jinping a lifetime appointment because they know they are in dire straits, and the existing leadership is best equipped to deal with the coming crisis versus a new leadership team. The U.S. and many other countries are deeply in debt, but debt levels in China, both sovereign and private, are at such astronomic levels that a total collapse of their financial system is a possibility. When, I don’t know, but the world’s second largest economy is on very shaky ground.
The Trade of The Decade
Our team has been cognizant of the herd mentality and crazy valuations of the market indexes for all of 2017, and this past January. We also realized that the VIX index, which hit a record low of 8 in January, was incredibly low. The VIX index is a measurement of investor sentiment. The higher the VIX the more worried and cautious investors are. The lower the number the more complacent and comfortable. The VIX went as high as 80 in the last recession, and January’s 8 was an all time low. The long time average of the VIX is 20. This is the background for my partner Brian Laks coming up with the “the trade of the decade.” Brian writes the following:
Some of the biggest beneficiaries of declining volatility levels over the past two years had been exchange-traded products tied to the VIX, specifically those with an inverse return profile such as the XIV and SVXY. As volatility declined, profits from their short contracts and inflows from investors caused assets under management to balloon to several billion dollars by early 2018.
The daily rebalance mechanisms of these products created a positive feedback loop in which increases in assets required further short sales to maintain their required level of exposure. These actions, given their growing size and influence in the futures market, served to further depress the price, leading to further gains, attracting more inflows, etc. Investors in these products were either unaware or unconcerned that this dynamic could also operate in reverse.
With an inverse Exchange Traded Product (ETP), a 100% increase in the underlying index would lead to a 100% decrease in its value. As the VIX dropped lower and lower, the absolute amount it needed to rise in order to double naturally decreased as well. At one point it was estimated that as little as a 3% decline in the S&P would cause a corresponding rise in the VIX that could trigger a violent unwind of their positions and total loss of their assets.
In such an event, a simple short position would yield a 100% return. By using options, however, we could limit the capital at risk and greatly magnify the potential return. Because only SVXY had associated options, we chose that as the underlying instrument. Since the maximum value of a put option is the strike price, we compared each available strike price to its asking price to determine which contract offered the highest return.
The threshold was triggered on February 5 as markets fell precipitously and the VIX spiked higher. After the close, VIX-linked ETPs were forced to rebalance by purchasing huge amounts of futures contracts in a rising market where sellers had all but vanished. The losses they suffered were devastating. On February 6, after being halted until mid-morning, SVXY opened down over 80%. While not a total loss, the contracts we had purchased were well in the money and we sold them at a profit of roughly 13,000%, a 130-fold return on our investment.
It is extremely difficult and rare to find situations that offer such “hundred-bagger” return potential. While ‘trade of the decade’ might seem to comment on such an outsized return, it perhaps more accurately reflects the decade of distortion in financial markets that it took for the opportunity to appear.
Normally I highlight one or more of our holdings in these quarterly letters. This quarter we are providing an excerpt from the recent issue of “Hidden Value Stocks,” a publication written for industry professionals where Old West is a featured investment manager. In the interview, my partner, Joe Boskovich Jr., goes into detail on one of our more exciting investments, Zedge Inc. (ZDGE, Financial), and my partner, Brian Laks, explains our investment thesis is Carbo Ceramics (CRR, Financial).
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When searching for investment opportunities, Old West often seeks to identify management teams with successful track records of allocating capital, and Zedge’s controlling shareholder, Howard Jonas, has impressively compounded shareholder value for decades. Jonas has opportunistically grown his holding company, IDT Corporation, organically and through acquisition, and when appropriate, he has monetized various unrelated business assets through sales and spinoffs (Zedge is one of his more recent spinoffs).
What does this company do and why do you think it has potential?
Zedge (ZDGE, Financial) is an early stage tech company focused on mobile device personalization and the distribution and monetization of digital content. Up until recently, the company’s sole business was in providing ringtones, wallpapers, home screen icons, and notification sounds to its users. Although wallpapers and ringtones may sound a little gimmicky (which was our initial reaction), the app has been overwhelmingly popular and has a massive and engaged user base with 306.2 million installs and 35.5 million monthly active users ("MAU"). This represents meaningful traction that is extremely difficult to replicate. Zedge has also been one of the Top 25 Free Apps on the Google
Play store for 6 years running, is one of the top apps in the iTunes entertainment category, and according to Apptopia (an app store intelligence provider) Zedge was amongst the 2017 worldwide download leaders. Zedge currently generates $12 million in annual revenue, has 80%+ gross margins, is profitable, has plenty of cash on its balance sheet, has no debt, and MAU and revenue per MAU has been growing rapidly.
- How do you see growth unfolding going forward?
Zedge’s success has been impressive to date, but it’s extremely impressive when we consider that the company has made no material investments in marketing, user acquisition or advertising and hasn’t yet implemented a monetization strategy for growth beyond selling ad inventory to the advertising networks and exchanges. Our suspicion has been that Howard Jonas and Michael Jonas (Vice Chairman and Chairman) and Zedge’s management team, led by Jonathan Reich and Tom Arnoy, recognized the vast potential of Zedge’s substantial and loyal user base and knew that a greater monetization strategy could be developed down the road and fed into Zedge’s 35 million monthly active users and growing. That’s exactly what is happening. Zedge is in the process of building two new approaches to more effectively monetize its user base; “Zedge Collections” and “Zedge Premium”, both of which have very exciting potential.
- Can you give our readers some insight into these new offerings? Why don’t you start with Zedge Collections?
As Zedge’s popularity grows, it has become an increasingly attractive platform for brands wanting to integrate with Zedge’s core offering to promote their content to consumers. The app packages a portfolio of cover art and other digital content and makes it available to users to set as their phone’s wallpaper, share via social media, or use in some other fashion. In doing so, Zedge provides brands with perhaps the most valuable advertising space: the home screen of the consumer's mobile device. Zedge is also able to provide valuable personal data on its users, enabling brands to directly target consumers that have engaged with their content regarding relevant product and service offerings via push notifications. To date, Zedge has formed partnerships with movie studios to promote a variety of upcoming movie releases, and sports brands such as the World Series of Fighting, the Washington Wizards, and X Games. For example, Zedge recently provided branding for Warner Brothers, “The Justice League”, ahead of its release. Zedge's app incorporated the movie trailer for users to click through and view, wallpapers, home screen icons, notification sounds and links to purchase tickets and Justice League merchandise. Zedge has only scratched the surface on this initiative, and we believe that Zedge will be viewed increasingly as a valuable platform for brands to distribute their content digitally and engage with their customers.
- And how about Zedge Premium?
Zedge Premium, which we believe has incredible potential, is a new marketplace for professional and amateur artists to monetize their content. To accelerate this rollout, Zedge acquired IP assets from Freeform Development in November 2017 and retained its co-founders Tim Quirk and Bryan Calhoun. We believe that this marketplace may become one of the more powerful solutions for illustrators, photographers, musicians, athletes, etc. to monetize and take advantage of digital distribution. More broadly speaking, we believe that Zedge will be a powerful platform for enabling the monetization abilities of anyone or anything with a following.
For a little background, let me first explain what Freeform Development had been building leading up to the Zedge acquisition. Freeform’s co-founder, Tim Quirk, had previously served as the Global Head of Content Programming at Google where he was one of the first people hired within the Android team to build and launch the Google Play Store. In this role, Quirk was responsible for merchandising all digital content, which included not only music (which was Tim’s background), but also movies and TV shows, books and magazines, and apps and games. In this role, Quirk quickly discovered that mobile game developers were light years beyond all other content providers when it came to taking advantage of digital distribution. Quirk learned that by shifting away from a model where success is measured in terms of total units sold towards a model where success is measured in terms of Average Revenue Per User (ARPU), the mobile gaming industry had figured out how to sell more digital content than any other segment and make lots of money doing it. Mobile gaming had essentially figured out the freemium model of giving its content away for free at first, and monetizing later down the road. One of the more eye-popping examples of this success is the mobile game Candy Crush Saga. Candy Crush Saga is a mobile game that has a gigantic install base of 392 million users, and the game is free to install and play. Of its 392 million users, 97% never generate a single penny for the company. However, of the 3% of its user base that does pay, mainly through in-app purchases, its developer, King, makes over $1 billion per year. App developers like King quickly learned that it was very difficult to get users to pay to install its game, but easy to get an install for free, and that people are more likely to spend money on in-app purchases (buying an extra life, buying a tool to help navigate a level, etc.) in free apps than to purchase an app that costs money to download. Although only a small percentage of users will ever pay (3% in the case of Candy Crush Saga), the serious fans will pay significant money once engaged.
These lessons led Tim Quirk and Bryan Calhoun to co-found Freeform Development to essentially figure out which of these lessons from mobile gaming can be applied to other segments of digital content, starting with the music business. Freeform’s intuition was that they could help music artists generate revenue beyond streaming royalties by connecting directly to their biggest fans, and if they were successful, the platform would provide labels, artists and managers a set of tools to let them control their own conversion funnel and enjoy game like conversion rates. Furthermore, it was their belief that artists should be able to have much higher conversion rates than mobile games, and their hypothesis was spot on.
The two central ides behind Freeform’s business model were 1) your album as an app, and 2) you should give your app away for free. The first concept of making your album an app was not recommended instead of selling it in iTunes or putting it in Spotify, it’s in addition to, but by making your album an app, it can be a much richer, deeper and more engaging experience. The album can have lyrics, photos and credits (just like albums had years ago), and it can have all kinds of things that weren’t possible years ago, like videos, game play, virtual reality experiences and direct interaction with the artist. The second concept, of giving your app away for free (and monetizing after the fact), should enable much higher conversion rates for artists. Artists have the ability to
determine what “free” means – they can set the parameters (allowing users to listen to one play per day on their album for free, the first five tracks on their album for free, etc.), but the general idea is to give the customer something for free so that they have a reason to install the app on their device. After the free offer is exhausted, the tracks lock, and to continue listening the customer must take some action to unlock them. That action can be clicking a buy button (which many people aren’t going to do), or the customer can take an action that doesn’t cost them any money but still generates revenue for the artist (watching a 15 second commercial or redeeming a partner offer like signing up for a free trial to Netflix or some other service). If a user signs up for that free Netflix trial, it’s not going to cost them any money, but just by trying it, they get unlimited access to the artists album. So, the artist ends up getting more fans because it’s a free offer, they get more revenue from every fan than if they sold them the record through iTunes in the first place, and the best part of all is that the artist now owns the customer relationship. It’s not Apple’s customer, it’s not Google’s customer, but it’s the artist’s customer, and the artist can get recurring revenue from those fans over time by selling them more music, tickets, merchandise, or some other experience.
Zedge’s Premium service will now extend Freeform’s monetization tools to all creators (scaling beyond music), enabling them to make more money from their content and connect with their biggest fans. Zedge premium was rolled out earlier this year on iOS and is just now being made available to Zedge Android users as well. The current platform includes dozens of professional photographers, illustrators, and graphic designers, several popular brands, about a half dozen musicians, and moving forward, I’d expect to see various other types of content rolled out. Current content in “Zedge Premium” can be unlocked with Zedge’s virtual currency (yet another interesting potential lever for unlocking future value) or by watching a 15 second advertisement, and additional unlocking actions will be introduced in time. The full vision for “Zedge Premium” will take time to realize, but we are very excited about its potential.
- This is a crowded space (apps and gaming). What gives Zedge an edge?
First and foremost, its giant and engaged user base of over 300 million installs and 35.5 million monthly active users (MAU) is a huge edge. This represents meaningful traction that is extremely difficult to replicate. Few companies have demonstrated this ability, and the ones that have are now owned by Google, Facebook, Microsoft or Apple.
I also think that the Jonas family brings an incredible amount of credibility to the company. As mentioned earlier, Howard Jonas has a phenomenal track record of success and has made a lot of money for himself and for his shareholders. Most early stage tech companies run out of money just short of their vision being reached. It gives us great comfort knowing that the likelihood of this happening to Zedge is rather small.
- How does this fit into your strategy of buying alongside management?
As highlighted earlier in this interview, Howard Jonas has a tremendous track record of success and fits our owner/manager criteria perfectly. Howard Jonas and his son, Michael, are the largest Zedge shareholders, owning roughly 23% of the outstanding shares. CEO, Tom Arnoy, and CFO/COO, Jonathan Reich, own an additional 8% of the outstanding shares.
- Has management been increasing their holdings recently?
Yes, from October 2016 through March 2017 Howard Jonas purchased roughly 400,000 shares of stock on the open market, and most of those purchases were at prices above todays stock price. While the amount of those purchases is small for Howard, it did represent almost 5% of the total Zedge shares outstanding and roughly 20x’s the daily trading volume.
- How are you approaching valuation today?
For starters, I think its important to reiterate that Zedge is profitable and has no debt, and that alone puts the company in a different class then most other app companies of its size.
Zedge currently trades at just a small fraction of revenue, EBITDA, and valuation per MAU when compared to similar acquired mobile apps, which suggests that Zedge should trade many multiples higher. For example, Microsoft bought LinkedIn in June 2016 at $60.51 per MAU, Facebook bought Instagram in 2012 at $33.33 per MAU, Google bought YouTube in 2006 for $33 per MAU, and Bytedance bought Musical.ly in November 2017 for an estimated $17 per MAU. Zedge has a sizable and engaged user base that should continue to grow significantly, and the company currently trades at $0.98 per MAU.
- What's your timeline for growth and bull target?
The full vision for Zedge will take time to realize, but I do believe that we are at the beginning stages of seeing increased revenue growth and a more rapid increase in Monthly Active Users. Zedge has spent the past years building its core user base and is just now unleashing greater monetization capabilities.
The new Premium marketplace is just starting to generate revenue for Zedge and its artists, and as artists successfully expand their reach and monetize their content within Zedge, new artists will in turn be attracted to the platform. Additionally, a portion of Zedge’s marketing will be outsourced to its marketplace artists as their fans and followers are attracted to the platform. As an example, let’s assume that Zedge grows to feature 10,000 different photographers, illustrators, painters, musicians, brands, athletes, and a variety of other content creators; if each of those 10,000 creators attracted 100 of their biggest followers and fans to the Zedge platform, that would result in a 1 million increase in Monthly Active Users. As Zedge features bigger content creators and brands, those creators may very easily attract thousands of fans and followers. If executed well, an increase of tens of millions of new MAU’s is easily within sight.
Given an increased MAU growth path and greater monetization capabilities, it would not surprise me to see Zedge trade at many, many multiples of its current stock price.
- And your base/bear growth target?
Zedge has proven to be very successful at attracting, retaining and growing a significant number of monthly active users ("MAUs"). Just based on current MAU, Zedge should command a higher MAU multiple of around $2 per MAU or a $7 stock price. As Zedge begins to monetize its existing user base with any success and revenue per MAU continues to increase, a higher MAU multiple of $3 - $4 per MAU is probably more accurate, which would translate to a $10 - $15 stock price.
This valuation accounts for no MAU growth, which is highly unlikely given its user engagement and monetization potential.
- Any final comments?
In summary, Zedge is an undervalued opportunity on a very popular platform with numerous potential levers to increase value. We believe that Zedge will continue to be thoughtful about these current monetization efforts as well as future efforts, which in return will drive continued user growth and more revenue per user. Once new initiatives are completely rolled out, the upside should be even more promising. We are very excited about this opportunity and believe that Zedge will be yet another successful IDT spinoff.
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CARBO CERAMICS (CRR, Financial)
- Let's begin at the start, what does this company do?
Carbo Ceramics is a technology company that provides products and services to the global oil and gas and industrial markets. Their primary product was historically ceramic proppant for the fracture stimulation of oil and gas wells where downhole conditions were too extreme for traditional sand proppant.
- How does it fit into the oil & gas world today (how is it coping with the downturn)?
Ceramic proppant volumes fell precipitously with the decline in oil prices as industry activity was curtailed and customers could no longer afford to use premium proppant in their wells. The company responded initially by expanding their traditional sand volumes to leverage their logistics capacity and more recently has begun servicing customers outside of the oil and gas industry with products such as ceramic grinding and casting material and material for mineral processing.
- What is the advantage of using Carbo's products over competitors' offering?
Regular sand proppant cannot withstand the high pressures of certain wells, such as many of those drilled in deep water or onshore at great depths. Other performance characteristics such as uniformity of grain and sphericity can also prove superior if commodity prices support the increased cost to operators. For industrial markets, the ceramic products reduce the amount of material needed, lower component wear and maintenance costs, reduce defects, and eliminate respirable silica dust to comply with strict OSHA exposure limits.
- Where do you see the growth coming from over the next few years?
The new end markets they have pursued have really begun bearing fruit. Whereas base ceramic accounted for over 80% of their revenue in 2014, the growth in other product lines has reduced their reliance on the segment to 30%, with 70% of their revenue now coming from other areas. That said, the continued strength in commodity prices has boosted activity levels across the industry, and their proppant volumes have increased for seven consecutive quarters after bottoming in Q2 16. We think there is potential for the company to “fire on all cylinders” going forward, with continued gains in both oil and gas and industrial segments. Their most recent quarter emphasizes this, with revenue growing 20% sequentially and over 100% year-over-year.
- Is the balance sheet strong enough to support it through the transition?
While they do have some debt ($88m as of Q4 17), it’s almost entirely offset by their cash balance. With cash from operations recently turning positive, the company has a long runway ahead of them to let this transformation play out.
- How did you first uncover the opportunity and what immediately attracted you to it?
The stock was down 25% on massive volume when they reported their Q3 16 earnings. Looking past the headlines, we noticed their total volumes had actually increased after six consecutive quarters of decline. In the week following the earnings release the CEO purchased over $100 thousand worth of stock on the open market. While the absolute amount was fairly small, what was significant was that it was his first purchase of stock in over two years.
- - What do you like about the management here?
It’s very refreshing to see a management team lay out a plan, especially when it appears the world is crashing down around them, and then execute on it quarter after quarter after quarter. This has been most evident in their operating cash flow, which improved from a $19m burn in Q1 17 to $15m in Q2, to $5m in Q3, and finally turning positive in the most recent quarter.
- Does management own a large stake and have they been buying more?
The chairman is one of the largest shareholders, with over 12% of the shares. The CEO is a top 20 shareholder and has been buying shares. The CFO and several Vice Presidents have all bought shares in the last year.
- Moving on to valuation: What valuation are the shares trading at today, and why is this appealing?
The company trades for less than half of book value, near its all-time lows, despite the fact that operations have been steadily improving. Because much of the improvement has come from restarting or repurposing idled capacity, capex requirements are minimal and the increase in cash generation is converting almost entirely to free cash flow. Given the distressed valuation, you don’t have to look too far out to see a double-digit free cash flow yield on a company with rapidly improving fundamentals. We don’t think that should be the case and expect the stock to rerate much higher when the market realizes that.
- Where do you see profitability moving over the next three to five years and how do you expect this to impact valuation?
With cash flow turning positive in the most recent quarter, we think net income will follow in the next few quarters and at that point analysts and market participants will start to revisit the name. Whereas much of the discussion a year or two ago was on whether the company would survive, once they show that their revenue growth is leading to sustained profitability the analysis should change to one of trying to value that accordingly.
- What's your bull case for the stock over the next five years?
It’s easy to forget when looking at the hard times that have fallen on the company that less than four years ago it was trading for $150 per share and was worth over $3 billion dollars. With the stock currently around $7 per share and under $200 million in market cap, it’s a far cry from those loftier times. Of course, back then oil was $100 per barrel instead of $60 and thus much of the fall has been warranted. We think in the near term, however, given the operational improvements and capacity for free cash generation, it’s not much of stretch to see it trading in the mid- to high-teens, which is our base-case valuation. In a bull case, oil prices continue to climb, activity levels and volumes increase and they have continued success in their non-energy businesses. In that scenario, we believe the stock will come back into favor and if the past is any guide we think the valuation will be much higher. We’re currently one of the company’s largest shareholders and we plan on owning it for a long time.
- And if things don't go to plan, what's the downside?
We believe downside risk is muted here, given the company still trades as though it is going out of business. The bear case is well-known (and very much alive with short interest over 50%!), which is that oil prices revisit their lows, activity levels and proppant volumes plummet, and the company’s diversification efforts are unsuccessful.
- Is there anything else that could change your view of the company?
Because they are reliant on the oil and gas and industrial sectors, any prolonged economic downturn would have a substantial effect on their end markets. We think the current valuation provides a margin of safety that would partially insulate them from this, but it would certainly temper our enthusiasm for their growth potential.
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Thank you for your continued support and loyalty and we look forward to growing your hard earned money the balance of the year and beyond.
Sincerely,
Joseph Boskovich, Sr.
Chairman and Chief Investment Officer
