Links for Thought -- March 9, 2012

Cost of Gene Sequencing Falls, Raising Hopes for Medical Advances (NY Times) -- This is a narrative I will continue to follow from both a science and investment standpoint.  We are at a very real tipping point in terms of the impact the Human Genome Project will have on our lives.  Ultimately deflation in the price of mapping the genome will help drive down the cost of medical treatment.  Just wait (and also read my post on the Innovator's Dilemma to create your own mental model for how this will play out).  

Selling Shovels in a Gold Rush (Leigh Drogan) -- Leigh Drogan, founder of Estimize, offers great insight on how some of those who prosper most from the present tech boom will be the ones who facilitate the boom along the way.  This is precisely how Levi Strauss made himself one of the most successful beneficiaries of the California Gold Rush.  

Warren Buffett: All that Glitters Is Tungsten (Benzinga) -- What's rarer than Rare Earths? Tungsten.  The most successful investor in the world, Warren Buffett has now taken a stake in a major producer via Berkshire's ownership of Iscar.  Tungsten is my favorite commodity investment and one I have been following for some time, as it has unique traits compared to most ordinary commodities.  Good to see Mr. Buffett give his implicit endorsement!

New Math Will Drive a U.S. Manufacturing Comeback (HBR Blog) -- HBR lays out the math behind why the U.S. is experiencing a manufacturing renaissance, and why this trend will accelerate over the coming years.  This is a highly compelling argument, substantiated by a good look at the numbers.  If the prediction is in fact correct, it bodes amazingly well for the U.S. economy.

Consumer Price Index (CPI): Comprehensive In-depth Analysis (ValueWalk) -- The CPI is controversial to many, for a variety of reasons. Here Kim Palacios at ValueWalk takes an excellent look at some of the ways in which the CPI is not properly constructed for the modern economy.  Substitution, sharing, and auction-based pricing all have serious consequences for the broader economic price level.  

Speculation Blamed for Global Food Price Weirdness (Wired) -- Yes Futures are an important tool for commodity consumers and producers to hedge their exposure, but, these days several crucial commodities seem inundated with speculators who are accumulating long-term positions.  This is leading to a disconnect in the true supply and demand equilibrium.  Food is far too important arena to allow such gamesmanship to influence everyday prices.

The Illusion of Understanding Success (Why We Reason) -- This is a great write-up on JK Rowling, the wildly successful offer of the Harry Potter series.  Rowling was in a state of depression before a twist of fate sent her life on a rapid ascent to stardom.  Too often society builds after-the-fact narratives of success as if someone started on the bottom left of a chart and ended at the top right without any bumps along the way.  This is a theme Daniel Kahneman has spelled out nicely, and one I will take a deeper look at sometime soon.  In the meantime, give this one a read.

Who Has the Moral Highground in A's-Giants Dispute (Baseball Nation) -- The Oakland A's and the San Francisco Giants are in the middle of a territorial dispute.  Tied into this fight is some interesting baseball history and more general questions about fairness. 

The Essential Mental Model for Understanding Innovation

The other day I came across this excellent video interview on the Harvard Business Review blog with Clayton Christensen discussing “disruptive innovation.”  As some of you may know, Christensen wrote The Innovator’s Dilemma.  This is one of the most important investment books for everyone to read.  It is essential for understanding the paradigm of innovation and disruption in business.  If there’s ANY tech CEO (or even non-tech CEO) who has not read this book I would have to seriously question their judgment as an executive.  This book is that important.  

Charlie Munger has told us investors that we need to have “mental models” upon which to build our world view and investment strategy (brief aside: there’s a really cool site called Think Mental Models which honors this investment credo.  I fully subscribe to this belief and as this blog develops, will look to share the models that are core to my investment philosophy).  The Innovator’s Dilemma, along with Porter’s Five Forces, create the lens through which to understanding the competitive landscape of any business, whether new or old.  Although the Innovator’s Dilemma tends to appear more relevant to the technology sector, as that is the home domain for the most high profile innovation in our economy, it is equally relevant to all industrial and service businesses alike.

The Dilemma

The crux of the dilemma is that there are outstanding businesses, highly attuned to their customers’ desires, outstanding at driving their product’s evolution forward, and supremely efficient at operating their businesses profitably, which ultimately succumb to failure.  Christensen labeled this a “dilemma” because these dominant market leaders fail precisely because of their managerial strengths.  This is so, because the smaller, innovative upstart competitors are willing to accept lower margins and lower product quality initially in order to break into niche segments beneath that of the dominant leader within the marketplace.  

By operating in this way, the young upstart is able to profitably grow a business while refining and developing the product until it eventually is a cheaper, better and eventually a replacement for what the dominant market leader has to offer.  Meanwhile, the market leader, in an effort to protect their market position and profit margins, and to cater to the needs of their largest customers, never enters into the new level to their core market because they refuse to take part in driving prices, margins and profits lower in the short-run.  Christensen narrates this phenomenon and develops the theory primarily through an analysis of the disk drive market, where these innovations tend to transpire at a far quicker pace than other arenas.  

Mark Suster, a “2x entrepreneur turned venture capitalist” wrote several outstanding posts on the Innovator’s Dilemma and how it not only impacts, but is a core element of his own personal investment strategy.  I highly recommend reading both The Amazing Power of Deflationary Economics for Startups and Understanding how the Innovator’s Dilemma Affects You. One point that I would add to Suster’s analysis is while the new firm accepts lower margins, they do so for particular products, not on a firm-wide scale.  These disruptive technologies are able to sell each unit of their product for a lower margin; however, their technology affords them the advantage to spread the fixed cost element in a much more beneficial way such that the firm-wide margins are far greater than the incumbent technology.  Typically the firm-wide advantage comes via the capacity to support enormous scale on a smaller operating structure.  This is particularly true in the Internet age.  And in this fact lies the ability to compete on price on a per unit basis.

Steve Blank is a pioneer in entrepreneurial theory, professor at Stanford and author of Four Steps to the Epiphany.  His impact is visible throughout the many innovative powerhouses born in Stanford.  He wrote an excellent post that relates the Innovator’s Dilemma to how large enterprises can cope and prosper in such an environment called The Search for the Fountain of Youth: Innovation and Entrepreneurship in the Enterprise.  This too is a must read.  

Investment Implications and the Mental Model 

Because these issues are so fundamentally important to companies both new and old, the connection to any investment strategy is important.  The s-curve model is the visual translation of the impact of the Dilemma.  (H/T to Your Brand is Showing for the graph)

 

 

As it pertains to market disruption, we look at the S-curve of the current technology relative to that of the emerging technology.  With every market leading technology, the product initially started off on a relatively slow growth trajectory.  Once it achieved a critical mass of adoption, the growth takes a parabolic trajectory; however, after adoption is ubiquitous, the growth plateaus.  Meanwhile, the young, emerging technology starts on a path beneath the current technology and crosses above the current in terms of both growth and efficiency (not necessarily quality just yet) at some point on its own parabolic phase of growth.  

These points are crucial for every investor, whether one focuses on growth or value.  For growth, the importance is obvious (invest in companies on the parabolic part of their growth trajectory), yet for value it's less so.  Understanding the Innovator's Dilemma is instrumental in determining whether some companies with solid track-records are experiencing a temporary blip, thus creating the value opportunity, or whether they are in fact being disrupted from beneath.  I look forward to sharing some anecdotal examples over time.

Links for Thought -- March 2, 2012

Apple: Thoughts on bias, value, excess cash and dividends (Musings on Markets) -- Two weeks ago, Aswath Damodaran brought us his valuation analysis of Facebook, this week he takes on Apple.  Aswath is a long-time Apple investor and a valuation guru.  He is generous enough to share not only his thoughts on Apple, but also his model.  Go check it out!

Mapping Solar Grid Parity (Energy Self-Reliant States) -- This is a really cool interactive map that shows when solar energy will hit grid parity around the United States.  Importantly this chart is taking a look at solar WITHOUT subsidies.  

The Silver Lining to Scarcity: It Drives Innovation (Harvard Business Review) -- Necessity combined with scarcity are powerful forces in the drive for innovation.  Too often innovation is not anticipatory, but rather reactionary to need.  Herein lies the "silver lining to scarcity."  This is a particularly relevant piece considering the questions about scarcity with regard to the future supply of crucial commodities like oil amidst surging emerging market demand.

Big Market Worries: Profit Margins (A Dash of Insight) -- Jeff Miller takes his stab at debunking one of the oft-stated mantras of today's market valuation: that margins are mean regressing and high, therefore they are due for contraction.  This is an important debate in establishing whether we are dealing with the real long-term compression of valuations, or whether this is simply a temporary uptick that will inevitably fade.  My belief--I side with Jeff.

Let Your Winners Run (A VC) -- Fred Wilson of Union Square Ventures tells us all to ride our winners.  When people see they are making money, it's very hard to take that itchy trigger finger off the sell button, especially in these days of high volatility.  Yet, to build outstanding performance over the long-run, it's important to recognize that the benefits of winners that keep growing are greatly increased by the effects of compound interest.  This is one of Kevin Douglas' strengths.

GeoEye--Eyeing Value in Satellite Imaging

Description:

GeoEye (NASDAQ: GEOY) is an integrated satellite imaging firm that owns the satellites in space and the on-ground image processing.  The company contracts these resources and the accompanying service to various government and private sector entities.  GeoEye has two satellites in orbit already—the IKONOS and the GeoEye-1—with a third preparing for launch sometime during the course of 2013.  GeoEye-1 has a resolution of 41 centimeters, while GeoEye-2 will have a resolution of up to 25 centimeters, with the highest precision reserved for the U.S. government only.  Satellite imaging is used for a variety of purposes, including but not limited to defense, disaster response, air and marine transportation, oil and gas exploration, mining production and exploration, mapping of remote regions, location-based services, insurance and risk management, agricultural crop management, etc. 

Valuation:

The stock is trading at a discount to book value at $22.01/share.  Tangible book value checks in at $18.17/share.  Where the book value analysis gets more interesting is in trying to build out a reproduction value for the company.  GEOY carries their satellite value at $817 million on their balance sheet, with $145 million of accumulated depreciation.  The company’s first satellite, IKONOS has been fully depreciated since 2008, yet it remains in space and producing revenues for the company.  The company operates in a capital intensive business, with significant barriers to entry, where the useful life of the assets is demonstrably longer than the time in which they become fully depreciated. 

Looking at this first from the asset valuation lens, it becomes clear that for a competitor to reproduce the business that GEOY has already built would cost substantially more than the carried value on the books of the satellites.  For the sake of simplicity, I think it’s fair to say that at the very least, a competitor would have to spend an amount equal to the carried value of the satellites, plus the already accumulated depreciation of $145 million, in order to viably compete with GEOY.  In adding that back to the tangible book value of the company (all goodwill has been excluded) you get an adjusted reproduction value that is approximately $24.50 per share.  That is a 20% premium to today’s share price.

There is further hidden value at the company in the form of a cost-share agreement with the US Government for the launch of GeoEye-1, the first color, high-precision commercial image satellite launched into space.  GEOY accounts for the cost-share payments in the following way: “amounts received from the U.S. government are recorded as deferred revenue when received and recognized as revenue on a straight-line basis over the useful life of the satellite.”  The gross amounts of the deferred revenue are carried in the company’s backlog and not on the books themselves until the payments are actually received from the government.  Once the payments are received they are then carried as deferred revenue until they are recorded as revenue alongside the corresponding amount of depreciated cost for the satellite itself. 

For 2012 and beyond, there is a total of $148 million left of repayment for the cost on the GeoEye-1 that the government pays out as $6.0 million monthly, or $24 million per quarter.  Using a 12% discount rate on the remaining contract, it has a net present value of $110 million to the company.   I added $110 million to the company’s reproduction value, because this provides further clarity about what a private market valuation would be, and what a potential purchaser would have to pay to buy the company.  Plus there is a substantially high degree of certainty that this money will reach the company, irregardless of whether the government scales back on commercial satellite contracts (to be discussed more in risk factors below).  When this is added to the tangible asset value, it gives the company an adjusted book value of $29.50, a 40% premium to today’s market price.

Next, I added the $110 million in NPV for the backlogged GeoEye-1 cost share into the cash value for my earnings power valuation and subtracted the $24 million annual amount that will be recorded as revenue from the actual earnings themselves.  This helps provide a more realistic valuation of the company’s actual earnings power.

At present, the company’s earnings power value is below both its carried book value and my adjusted book value.  This typically indicates that management is destroying value equal to the difference between the actual book value and the earnings power value, for even a company in a perfectly competitive environment’s earnings should be equal to the value of the underlying assets themselves.  That begs the question, is management destroying value?  And I think the answer is clearly no.  There are several factors that negatively impact the earnings power value, one of which is the revenue recognition for government contracts, and the accelerated depreciation schedule for these satellites compared to the actual useful life.  Also relevant is that once the GeoEye-2 enters space, the company has an existing contract with the government that will have the U.S. paying an additional $183 million per year for imaging and the commensurate services.  When this is in place, the company’s earnings power will be $22.60 per share using a 12% WACC.

Competitive Advantages

It’s important to assess the competitive advantages for any company, particularly one in which the claim is made that the reproduction value is greater than both the asset value and the present earnings power value.  Further, in order for a company to earn real economic profit, they need some kind of competitive advantage.  Here is where the company is particularly unique, as GeoEye benefits from several crucial advantages, many of which pertain to barriers to entry.  First, is the capital intensity of the business, as satellites are expensive to build and expensive to launch.  For a startup company in the field, they would have to raise substantial capital just to get into a position to win a contract, let alone, develop the team and experience to manage the equipment itself. 

Next and most importantly, are the regulatory barriers to entry.  Not anyone can just launch a satellite into space.  Permissions are needed at various steps along the way.  Permission must be obtained for the launch itself, permission must be obtained to allow the satellite to orbit, and last, permission is needed from both a Defense and Intelligence standpoint from the government in order to take imaging of the entirety of the Earth.  For logical reasons, the government doesn’t want anyone and everyone to be able to take whatever pictures of the Earth that they would like, and as a result, the government has historically monopolized and dominated this field for themselves.  Collectively, the governments of the world with the capacity for astrodynamics have complete control in deciding who can and cannot launch and operate satellites, and as such, the regulatory barriers are substantial.  Further, once a satellite is in space, orbiting and providing a service, it is increasingly unlikely that the government would allow yet another satellite for the same commercial purposes.  The reasoning here again is simple, while space itself is vast, the space in which imaging satellites can orbit is finite.  The more crowded that orbit zone is, the more likely it is that some problem would arise. 

One limit to the GEOY’s competitive advantage is that in exchange for the government subsidizing a portion of the build and launch fees, and having done so following a competitive bid process, the company has little bargaining power for the costs of its services with its largest customer.  This limitation is mitigated however, as the government authorizes GEOY to seek additional clients, including foreign governments and private companies, for services in which there is little competition for the reasons mentioned above.  As such, the amount of services that can inevitably be sold are very scalable once the satellites are in orbit. 

Customers

As of now, the US government remains the largest client of GEOY, and this should continue to be the case as the government scales down its own space operations.  The US government itself represents approximately 2/3rds of the company’s revenues.  GEOY has several long-term contracts with the government, the largest of which was signed in August 2010 and can reach a value up to $3.8 billion.  The problem with this particular contract, and one of the overhangs plaguing the stock, is the government’s option to renew the contract annually, instead of it being guaranteed for the full term.    

With the government’s budget under scrutiny and in a state of uncertainty, particularly with regard to defense spending, investors are discounting the potential value of this contract over the longer-term.  The large contracts are with the National Geospatial Intelligence Agency (NGA) within the Defense Department.  Duncan Scot Currie, the director of NGA’s commercial satellite operations had the following to say: “It’s a tough budget environment, but I am confident we can demonstrate the value of this program to the Congress.  We have a contract that is providing tremendous value to the U.S. government and we are on schedule and on budget for developing the next generation of commercial satellites. It is reasonable to assume that budgets across the board are going to be reduced. Everybody’s going to be affected. We hope we can manage it.”

GeoEye-2 is slated to launch during 2013 along with the NGA’s other large commercial satellite customer, DigitalGlobe.  The NGA has asserted they think all contracts would “stand up to the scrutiny” (quoting a paraphrase).  It seems as of now the repercussion may be adding an additional “passenger” in the form of another satellite to the slated launch on the Atlas 5, a comparatively expensive spaceship, but one that is fully domestic in terms of build and operation within the US.

Beyond the US government, other governments around the world have contracted for GeoEye’s services, and in the private sector.  In the private sector, Google uses GeoEye’s satellites for Google Earth.   Just this year the company announced a “multi-million dollar contract” with the Russian government to provide imaging services, however the full terms have yet to be disclosed.

Large Buyer of Shares

Cerberus Capital Management is the single largest stockholder in GeoEye and they keep on growing.  The relatively secretive private equity firm, with an outstanding track-record has bought shares as high as the $40s, and continues to accumulate their stake today.  Cerberus so badly wants to buy GeoEye that they negotiated with the company and its other large stockholders to allow for an increase in the maximum beneficial ownership interest one can take before becoming an “Acquiring Person” which triggers a poison-pill against acquisition.  The poison-pill was adopted during the course of 2011 and limited the maximum ownership to 20% of the outstanding stock before triggering “Acquiring Person” status.  In late 2011, this maximum threshold was raised to 25%, and in early 2012 it was again raised, this time to 30%.  Each time this threshold was raised, Cerberus quickly commenced further open market share purchases.  Cerberus also holds debt positions in the company’s stock.

Cerberus, through its portfolio companies, is one of the 100 largest government contractors, and has deep ties with the Defense Department and government itself.  They clearly understand the risks inherent in the Defense Department budgeting process, yet despite these known risks they continue to buy more.  It’s unclear exactly what Cerberus intends to do with their massive stake in GeoEye (i.e. whether they intend to eventually take over the company, or just hold it passively), but what is clear is they believe that the valuation here offers a very compelling long-term investment opportunity.

In the past there had been abundant takeover rumors regarding Cerberus’ stake, having either Cerberus buying out the remainder of the firm, or setting up an acquisition by one of the other defense contractors looking to gain a foothold in the satellite imaging sector.  While that is a possibility, I am not factoring in that likelihood in my analysis of the stock.  More realistically, what I think Cerberus may do is facilitate commercial contracts between GeoEye and their various portfolio companies offering contract services to the government.

Risks:

The primary risks to the company today relate to the uncertainty over the Defense Department’s budget moving forward.  Any large contract is subject to scrutiny, and as such, it’s impossible to determine exactly which ones will remain in force and which will be cut.  As of now, the NGA’s budget has been cut by 10% for 2012, but not all the cuts will necessarily reach through to GEOY and the NGA's budget itself is classified so it's impossible to determine exactly what the impact will be as of yet.  In April of this year, the White House will release the results of their own review of the EnhancedView contracts for satellite imaging services, and at that time there is the potential for further cuts from 2013 on, or for the confirmation that the conracts will proceed as planned. 

As part of the review, the government is looking into the scheduled launch of GeoEye-2 aboard the Atlas 5 rocket.  There is the potential for the government to require additional space-bound projects on the launch, which could delay GeoEye-2’s launch date.  Any delay in the launch would push back the revenues GEOY is set to receive.

While it’s certainly possible that the contracts are scaled back, it seems highly unlikely that they would be cut entirely.  The NGA has asserted that they “support commercial imagery as a vital part of geospatial intelligence, and EnhancedView as part of the commercial imagery program.”  President Obama specifically credited the NGA with their crucial help in the operation to capture Osama Bin Laden and in this age of heightened tensions in the Middle East, combined with an increasingly war-weary American populace, satellite imaging is an invaluable tool in modern warfare.  Further, with global warming increasingly a problem, satellite imaging has emerged as an important tool in disaster readiness and disaster response management.  It's hard to imagine cuts will run too deep in this space.

Author Disclosure: No position, but may initiate within the next 72 hours.

Evgeni Malkin Scores an Amazing Goal

Yesterday Evgeni Malkin scored one of those hockey goals that will stand out for a while.  Malkin, starting at his own blue line, took no more than six strides in cruising past the entire Tampa Bay Lightning team on his way to slamming the puck into the back of the net: