Buffett’s Eye on Google’s Moat

Some recent fussing over Google has followed from an unlikely source—the Berkshire Hathaway annual meeting. During a Sunday press conference, Charlie Munger quipped that “Google has a huge new moat. In fact I’ve probably never seen such a wide moat.”

Unfortunately, Charlie’s brevity and the reporters’ lack of curiosity leave the reader to surmise what he really means. Warren Buffett kindly filled a bit of the gap when he added that Google’s search-linked advertising is “incredible.”

At a basic level, their observations are hard to dispute. Any time a brand name enters our common lexicon, one can assume that their product has attained sufficient “share of mind” to command pricing power. Even the most ardent Yahoo-er would not be so uncouth as to “yahoo” the web for an answer.

As if seeking confirmation, many leapt to conclude that Buffett and Munger now find Google a great investment. Yet a wide moat does not a great investment make. And I can think of no better criteria for an investment than those which have served Buffett and Munger so well over the years, and which are annually reproduced in Berkshire’s annual reports. An investment must have: 1) demonstrated consistent earning power, 2) earn good returns on equity while employing little or no debt, 3) have honest and able management, 4) operate in simple businesses, and 5) be available at a fair price (somewhat below its intrinsic value, to provide a margin of safety).

Given these criteria, Google couldn’t pass as a viable investment for two reasons—it is too difficult (likely impossible) to forecast what the “search” market will look like in ten years, and Google’s equity currently sells at a premium price. One only needs to look back ten years ago to see a Google with no “share of mind.” For Buffett and Munger, Google’s moat—like Microsoft’s—is extremely wide, but its durability is unknowable.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

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Candid Management and Widening Moats

[This article first featured on the DIV-Net on April 28, 2009]

Spring is the season for annual reports, and many executives use the occasion to spin a few tales about business in the year past. Though ostensibly these are letters from management to the boss—that is, the owners—far too many seem to take their storytelling lessons from the habits of evasive, guilty teenagers. On rare occasions one finds an honest, clear assessment of the year’s work, and such candor is impossible to miss. For the investor, the spring season is one for assessing the pen of management, in order to discern trustworthy and honest stewards of capital.

Of course, candor from management has almost become an endangered species in recent years. Rittenhouse Rankings Inc. has followed this trend with its annual CEO Candor Scores, and in 2007, found that in shareholder letters “confusing and misleading statements or “dangerous fog,” increased 66 percent… up from 39 percent five years ago.” Instead of providing an impartial and clear analysis of successes and failures, more and more executives speak their Orwellian language, using “words to describe ‘the truth we want to exist,’ rather than facts.” And the point here is not merely pedantic, for Rittenhouse Rankings argue that “high candor scores and rankings reveal high quality leadership, cohesive corporate cultures, more reliable accounting and superior financial performance.”

One CEO known for his candor is Wells Fargo’s John Stumpf.

In his most recent letter to shareholders, Stumpf makes good on his reputation. Though Wells Fargo acquired Wachovia in one of the largest banking acquisitions in the last year, Stumpf does not trumpet their size, for “where [Wells ranks] in asset size alone is meaningless to us… In fact, to our customers, bigness can be a barrier. I’ve yet to hear of a customer walking into one of our banks and saying, “I want to bank here because you’re so … big!”.”

For Stumpf, Wells’ annual success should be determined by two metrics—revenue v. expenses, and return on equity. Regarding the first, Wells’ revenue grew six percent in 2008, while expenses declined one percent—“the best such revenue/expense ratio among our large peers, and the one we consider the best long-term measure of a company’s efficiency.” And on the second, Wells’ return on equity was 4.79 cents for every dollar of shareholder equity, best among their peers for the year. By the numbers, Wells did more with less than the year before, and it had better returns on shareholder capital than peers. Even in a difficult macroeconomic environment, someone had to be the best. For the large American banks, 2008 was the year of Wells.

As an investor, Stumpf’s candor is refreshing, but his focus arguably more important. Rather than telling a lengthy and jargon-laden tale of Wells’ growth or enigmatic synergies, Stumpf reveals his concentration on managing his owners’ capital productively, and optimizing aspects of Wells’ business that he can control. Increasing the loan portfolio may not be a productive use of capital: only if it can be done at adequate margins, and without excessive expense. Rather than spinning a grand story of how our economy went wrong, Stumpf keeps his eye on his business and intelligent opportunities for growth in the year ahead. Though these two tasks need not be exclusive, experience shows that too many bankers love to indulge in forecasting and professoring.

In our assessment of economic moats, managerial ability, more than almost any other factor, directly correlates with the width of a business’ moat. Like Andrew Grove, the best managers are capable of rebuilding a protective moat with a new product, even as past competitive advantages deteriorate. Like Warren Buffett, the best managers are capable of redirecting the life blood for building moats—capital—to the best castles with the ablest builders. Like John Stumpf, the best managers are capable of concentrating their gaze on matters they can control, and each day use capital a little better than the day before.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Buffett’s Berkshire Letter for 1986

1986 saw seven million people join hands in Hands Across America–a well-publicized, but unsuccessful attempt to raise $50 million to alleviate famine in Africa.  Later in the year, the Iran-Contra Affair features on the public page, revealing that the United States had sold weapons to Iran in exchange for the release of 7 American hostages held in Lebanon.  And the stock market had drawn its share of helium, with S&P soaring from its open near 165 to close the year near 210.

Over at Berkshire, net worth increased by $492.5 million, or 26.1%, and for those keeping score (be assured the Chairman is), that signifies an increase of 10,600% over 22 years, from $19.46 to $2,073.06 per share.

The good news for Berkshire’s owners is that they own a grove of money trees; the bad news is the fruit of their grove has not found fertile ground to grow tomorrow’s trees.  In the stock market, where Buffett and Munger had previously found abundant fertile ground, the terrain now looks sterile and barren. The best available alternative in 1986 then was to pay off debt and stockpile cash. Though “neither is a fate worse than death, they do not inspire us to do handsprings either. If we were to draw blanks for a few years in our capital-allocation endeavors, Berkshire’s rate of growth would slow significantly.”

After some obligatory back-slapping and “atta-boys” for Berkshire’s managers, Buffett talks the business. At Buffalo Evening News, they have attained both the highest weekday and Sunday penetration rates (near 83% on Sunday) of the top 50 papers in the country. At Nebraska Furniture Mart, net sales increased 10.2% to $132 million, and the only logical explanation for their success is “that the marketing territory of NFM’s one-and-only store continues to widen because of its ever-growing reputation for rock-bottom everyday prices and the broadest of selections.” At See’s Candies, their “one-of-a-kind product ‘personality’” derives from “a combination of [their] candy’s delicious taste and moderate price, the company’s total control of the distribution process, and the exceptional service provided by store employees.” More than any other metric, See’s manager Chuck Huggins “measures his success by the satisfaction of our customers, and his attitude permeates the organization.”

The big news of the year are Berkshire’s acquisitions of Scott Fetzer (which includes World Book and Kirby) and Fechheimer, a uniform manufacturing and distribution business. In the case of Fechheimer, its Chairman Bob Heldman had concluded that their company fit Buffett’s criteria for desired acquisitions: “1) large purchases (at least $10 million of after-tax earnings), 2) demonstrated consistent earning power, 3) businesses earning good returns on equity while employing little or no debt, 4) management in place, 5) simple businesses, and 6) an offering price.”

And Heldman was right. As Buffett recounts, “Fechheimer is exactly the sort of business we like to buy. Its economic record is superb; its managers are talented, high-grade, and love what they do; and the Heldman family wanted to continue its financial interest in partnership with us… the circumstances of this acquisition were similar to those prevailing in our purchase of Nebraska Furniture Mart: most of the shares were held by people who wished to employ funds elsewhere; family members who enjoyed running their business wanted to continue both as owners and managers; several generations of the family were active in the business, providing management for as far as the eye can see; and the managing family wanted a purchaser who would not re-sell, regardless of price, and who would let the business be run in the future as it had been in the past.” For those curious, Fechheimer earned $8.4 million pre-tax in 1986, and the purchase price valued the entire business at 6.5x pre-tax earnings.

Lastly, over at the insurance businesses, prices have firmed and premiums boomed, likely making Berkshire “the fastest growing company among the country’s top 100 insurers.” Not only that, but the cost of their insurance float fell, with Berkshire’s combined ratio falling from 111 in 1985 to 103 in 1986.

Despite Berkshire’s performance, they were no match for their partially-owned competitor GEICO. Under the leadership of GEICO’s Chairman Bill Snyder and with the investing acumen of Lou Simpson, GEICO’s moat grew considerably. As Buffett observes, “the difference between GEICO’s costs and those of its competitors is a kind of moat that protects a valuable and much-sought-after business castle. No one understands this moat-around-the-castle concept better than Bill Snyder, Chairman of GEICO. He continually widens the moat by driving down costs still more, thereby defending and strengthening the economic franchise. Between 1985 and 1986, GEICO’s total expense ratio dropped from 24.1% to the 23.5% mentioned earlier and, under Bill’s leadership, the ratio is almost certain to drop further.”

All told, the businesses performed well in ’86, but the stock markets offered few bargains. As a temporary home for Berkshire’s growing piles of cash, Buffett begrudgingly took some positions in merger arbitrage, for “common stocks, of course, are the most fun. When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value – stocks sometimes provide grand-slam home runs. But we currently find no equities that come close to meeting our tests.”

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

[Also, check out our other posts in our Berkshire Hathaway Letters Series.]

Pricing Power and Economic Moats

What products do you use that you would be willing to pay double the current price? Food and energy, being necessities, would be likely candidates. Of course, doubled prices would likely change your consumption habits. How about discretionary items? Books, news subscriptions, your iPhone?

Yesterday we observed Warren Buffett describing the importance of investing in businesses that could raise their prices “rather easily without fear of significant loss of either market share or unit volume.” In 1981, consistently raising prices was a necessity for business survival, with the consumer price index increasing at 10% annually. For Buffett, inflation was a giant corporate tapeworm, which “preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism.” In many ways, highly competitive environments often treat a business in the same way; as the competition spends capital to update its stores, you have to spend just as much to maintain your market share.

Excellent businesses then—those with wide economic moats—are able to survive difficult macroeconomic environments because their products carry pricing power. For Buffett, See’s Candies and Coca Cola wield this power; for See’s, Buffett has unfailingly increased prices on the day after Christmas.

These days, newspapers, magazines, and periodicals—faced with declining advertising revenues—are considering price increases. As The New York Times recently reported, the average Time subscriber only paid 58 cents per issue, and Newsweek readers paid 47 cents. True to its moniker, The Economist raised its price per issue to $6.99 last year, all while seeing its subscriptions rise 60% since 2004.

At our house over the last few months, we have been surprised to find—instead of subscription notices—cancellation notices from publishers. With declining advertising revenues, these periodicals were forced to close their doors for good. And I recall thinking—why didn’t they raise their prices? Because I would have easily paid twice what I had been.

For many goods and services, tight economic times trigger the tightening of budgets. However, even during such times, the most desired goods and services will still command a premium and increasing price. For the investor, these are the wide moat businesses that should find a home in one’s portfolio, at an attractive price.

So, is The Economist for sale?

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway.

Moody’s Shrinking Moat

Moody’s Corporation is “a provider of (i) credit ratings and related research, data and analytical tools, (ii) quantitative credit risk measures, risk scoring software, and credit portfolio management solutions and (iii) securities pricing software and valuation models” (10-K from 3/2/09).  They operate their business in two segments—Moody’s Investor Service (MIS), which primarily rates debt securities in the global capital markets, and Moody’s Analytics (MA), which provides “quantitative credit risk scores, credit processing software, economic research, analytical models, financial data, securities pricing software and valuation models, and specialized consulting services” (10-K from 3/2/09). The foremost competitor for MIS is Standard and Poor’s, owned by McGraw-Hill Companies, though Moody’s also shares the ratings market with Fitch, Dominion Bond Rating Service Ltd. of Canada, A.M. Best Company Inc, Japan Credit Rating Agency Ltd., Rating and Investment Information Inc. of Japan and Egan-Jones Ratings Company.

The consensus view among stock market participants is that Moody’s Corporation has one of the widest economic moats around. Having provided credit analysis for a century now (going back to founder John Moody’s 1909 Analyses of Railroad Investments), and proven its value in predicting potential distress, the credit rating from MIS has become a necessity for large public companies seeking capital in the debt markets. The particular beauty of Moody’s business is that its standard credit analysis relies upon formulas back-tested against deep deposits of credit data from a wide variety of economic environments. Their value comes not from innovative analysis, but from having the most reliable and demonstrated tools in the room. Even if a competitor had access to such a database, and even if they found a better set of predictive metrics, few would pay to take their views seriously until they had acquired a history of predictive analysis.

Of Moody’s two segments, MIS clearly brings in the majority of Moody’s revenue ($1.2 billion for MIS in 2008 v. $1.755 billion total). Moody’s Analytics (MA), despite robust revenue growth in 2008 (14.9%), offers some products for which competition is stiff—consulting, economic research, and financial data. Though Mark Zandi’s economic analysis at economy.com may add insightful commentary, his voice does not add enough to command meaningful revenues for Moody’s. The best part about the MA business is that it is easily scalable; all the content is already prepared, so incremental revenue yields much fatter profits. Though MA may not offer an indispensable product like MIS, its growth prospects and its easy fit with its primary business appear to provide Moody’s owners with desirable returns on invested capital.

Ultimately though, the crucial aspect of Moody’s economic moat is their reputation for providing a useful and predictive judgment about credit risk. So how wide and deep does their reputation currently extend? In short, not as wide and deep as five years ago.

As many know, in recent years, Moody’s expanded its credit ratings to include structured finance products (e.g., RMBS, CDO). Given their relative novelty, and their concentration in excessively levered, overpriced “assets” (i.e., houses), Moody’s ratings proved unreliable for predicting distress and default rates. And their reputation as a whole took a significant hit. As they acknowledge in their 10-K, “Moody’s reputation is one of the key bases on which the Company competes. To the extent that the rating agency business as a whole or that Moody’s, relative to its competitors, suffers a loss in credibility, Moody’s business could be adversely affected.”

Here today, it is difficult to assess how damaged Moody’s reputation may be. Though structured finance made up the largest share of MIS revenues in 2007 ($873 million), it still composed less than half of their overall revenues ($1.78 billion). In other segments—corporate finance, financial institutions, and public finance—MIS credit ratings have not yet proven unreliable indicators. Yet, with their recent mistakes in structured finance, Moody’s has created an opening for a new competitor with better (or even passable) tools to steal share.

Later this week–Moody’s Intrinsic Value

Disclosure: No position

Warren the Impulsive?

In the summer of 1983, Warren Buffett sauntered into Nebraska Furniture Mart, then Omaha’s privately-owned, market-trouncing behemoth run by Rose Blumkin and her family. After a look around, Buffett asked “Mrs. B” to sell him the place. Mrs. B said sure, for sixty million. Buffett shook her hand, and the deal was sealed.

A familiar story for Buffetteers it is. And told so, it affirms the mystique associated with Buffett’s decisiveness. As he himself has relayed in his annual letters, business owners looking to sell can usually receive an answer from Buffett within five minutes.

Yet, as with most good yarns, the real history rarely runs that way. In the case of Nebraska Furniture Mart, Buffett had been stalking the furniture giant for quite some time, having even made an offer much earlier in his career, which Mrs. B deemed “too cheap.” As Roger Lowenstein recounts in his Buffett: The Making of an American Capitalist (Random House: 1995), Warren had expressed his lust for the Mart to business writer “Adam Smith” in the early seventies, spouting off its operating statistics—volume, floor space, turnover, etc. And this for a private company.

Before that happy day in 1983 (Buffett’s birthday, in fact), Buffett had heard that Mrs. B was entertaining a $90 million offer from a German furniture retailer. Prior to his offer, Buffett had studied the Furniture Mart’s tax returns and found that it had earned $15 million pre-tax in years previous. Buffett had met with her son Louie and discerned the price point that Mrs. B had in mind. He knew that the Mart’s $100 million in sales commanded two-thirds of Omaha’s furniture sales, and its moat so wide that Dillard’s refused to sell furniture in Omaha. Mrs. B “had a toll bridge to the living rooms of Omaha” (Lowenstein 250).

I’ll admit—the familiar story tells better than the truth. But the truth will better serve the fellow investor. Decisive action may give the appearance of reckless impulse, but in the case of Buffett, it is merely a convenient façade that covers detailed preparation and measured calculation.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Morningstar’s Wide Moat Focus Index

As some may know, Morningstar currently has a Wide Moat Focus Index that “consists of the 20 securities in the Morningstar US Market Index with the highest ratios of fair value… to their stock price, and which have a sustainable competitive advantage…”

For those persuaded by the idea that some businesses have wider economic moats, but without the time or desire to go looking for them, the Index provides the investor with twenty places to start. As of 2/27/2009, the Index included Monsanto Company, Waters Corporation, Starbucks Corporation, Maxim Integrated Products, Fastenal Company, Zimmer Holdings, Applied Materials, Paychex, IMS Health, Forward Air Corporation, The Western Union Company, KLA-Tencor Corporation, Avon Products, eBay, International Speedway, St. Joe Corporation, Autodesk, American Express, Legg Mason, and Bank of America.

Even more useful is Morningstar’s description of their methodology for selecting the favored twenty. First, a business must pass the “show me the money” test, which demands that its return on invested capital (ROIC) has consistently exceeded its cost of capital. Having satisfied this initial screen, Morningstar analysts then assess whether the margin can be attributed to a clear competitive advantage. Morningstar classifies four major types of competitive advantage: high switching costs (e.g., Stryker), lower general costs (e.g., Wal-mart), valuable intangible assets (e.g., Harley-Davidson), or a sufficiently large network of users (e.g., eBay, NYSE).

Stryker benefits from high switching costs because surgeons that use their products would have a difficult time retraining their habits and skills to efficiently use a competitor’s. Wal-mart sells a wide array of basic consumer goods that could be purchased in numerous locations; that is, its products are practically indistinguishable—essentially commodities. In a commodity business, the only lasting advantage is being the perennial lowest cost producer, and in retailing that’s Wal-mart; in car insurance, Geico. Harley Davidson offers a product that its customers will pay a premium for (and then profess their undying love through abundant bodily art). eBay’s network of buyers and sellers offers each an optimal market experience; buyers find a rich selection, and sellers can solicit the largest number of buyers and presumably the highest prices.

Looking over Morningstar’s favored twenty, a couple businesses stand out. First, and perhaps with the benefit of hindsight, it is hard to imagine a retail bank like Bank of America with a sustainable economic moat. The little brick retail banks reign in ubiquity in our town, all seemingly offering similar rates and services. Though it may have been inconvenient to set up banking accounts in the past, online platforms have surely simplified the process.

American Express is also an interesting case. While swiping an AMEX used to carry some cache, today it is mere French vanilla. While American Express does have its credit card network, by sheer numbers, Visa’s and Mastercard’s stand superior.

All told, Morningstar’s Index highlights some interesting businesses for the wide moat investor. We’ll take a deeper look at some in the weeks ahead.

Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.

‘Only the Paranoid Survive’ Review

Only the Paranoid Survive (Doubleday, 1996), by Andrew Grove, former CEO and Chairman of Intel Corporation, is a book about “inflection points” in businesses and careers. Inflection points require radical change, but our habits of mind and past investments can make change difficult at these points. Yet, without the requisite change, the ultimate cost is even higher. Grove peppers his insights with numerous anecdotes from Intel’s experience with inflection points in personal computing, and the book serves as a extended illustration of what a CEO’s mind must be to survive—paranoid.

For Grove, Intel’s primary inflection point confronted them in the middle of the 1980s, when they, a company known for their memory chips, were in an increasingly weak competitive position relative to Japanese chip manufacturers. As Grove observes, “when a strategic inflection point sweeps through the industry, the more successful a participant was in the old industry structure, the more threatened it is by change and the more reluctant it is to adapt to it” (50). Intel’s case confirms the point. They were consistently losing money on their memory chips while trying to compete; some recommended building a new, more efficient factory; others recommended more research and development in the hope that a better product would emerge.

The inflection point came in 1985, after Intel had been waffling about their chip problems for almost a year. Grove and then-chairman and CEO Gordon Moore were sullenly batting around ideas when Grove asked “if we got kicked out and the board brought in a new CEO, what do you think he would do?” “He would get us out of memories” was Moore’s response. And from that day, Moore and Grove began the long and difficult journey of persuading Intel to cast aside its accumulated identity and shift its attention solely to microprocessors.

Given the interests of this blog, we found Grove’s laundry list of inflection points to be most useful. In retail, Wal-mart’s efficiency in logistics and its corresponding low prices have required competitors to specialize (e.g., Home Depot, Office Depot) or fail. The introduction of sound into film-making compelled actors to transform their skills or dwindle into obscurity. Containerization enabled the rise in prominence of Singapore’s and Seattle’s ports (where there was sufficient room to expand), and the decline of New York’s. General Motors’ aim to offer “a car for every purse and purpose” resonated with customers more than Ford’s formulaic duplications—“it takes you there and brings you back.”

All these examples highlight an exceedingly important point. Today’s competitive advantages may subtly erode much faster than even the most astute and attentive observers recognize. Wide economic moats protect the castle, but very few endure across a lifetime. Inflection points are the norm, and investors and executives must constantly be looking for them; cultivating paranoia may be wise. To have an economic moat is not enough, for the moat must endure to provide the investor with significant safety.

Disclosure: I, or persons whose accounts I manage, own shares of Office Depot at the time of this writing.

David Einhorn and Return on Equity

Here at Wide Moat Investing our primary task is to pinpoint the characteristics that separate good businesses from the great. So far, we’ve highlighted some qualitative characteristics that may not yield well to quantitative assessment (e.g., Coke has no “taste memory” and appeals to a basic, enduring preference). Yet, many investors begin their search for great businesses by using a handful of quantitative metrics. Margins are often important, for as we observed in our analyses of eBay and Microsoft, high gross margins may signal a business with significant competitive advantages.

Another important quantitative metric for many investors is return on equity (ROE).  For example, Francis Chou looks for excellent companies with a 15% ROE sustained over 10 years or more.*

David Einhorn, President of Greenlight Capital and hedge fund manager, addressed the topic of ROE in his November 2006 talk at the Value Investing Congress. There Einhorn argued that ROE is only a meaningful metric for capital-intensive businesses—like traditional manufacturing companies, distribution companies, most financial institutions, and retailers (4). For businesses that are not capital intensive—whose profits derive primarily from intellectual capital or human resources (e.g., pharmaceutical companies, software companies, etc.)—it is “irrelevant to worry about ROE” (4). Why? Because businesses that are not capital intensive do not generate substantial returns from retained earnings or capital expenditures. For example, if you are an insurance agent, you will bring in much more business and profit by getting on the phone and meeting more potential clients, rather than tripling your office space, or adding that new water feature to the atrium, or buying that highly efficient “document station.” In short, it’s not the “equity” which provides the retums, but the people, the brand, or the proprietary product—things which don’t show up on the balance sheet. ROE then is insignificant. For the most part.

You see, Einhorn observes, and experience confirms, that most non capital intensive businesses have an irresistible urge to direct excess returns back into the business that doesn’t need them, or to acquire businesses that do (i.e., capital-intensive businesses). And so the investment bank, which generates fees upon fees, largely due to its personal relationships with clients and its perceived brand, starts to pour excess capital into lending, trading, hedging, and gambling. Seemingly all of a sudden you have that old investment bank now asking its government for tens of billions of dollars, and it intensely needs the capital!

For Einhorn, the best explanation for such capital (mis)allocations is that such businesses are being run for their employees rather than their shareholders, employees running them just well enough to achieve a respectable 15% ROE, and sure enough, the shareholders’ respect keeps coming.

All told, we find Einhorn quite perceptive on these points. And we find his distinction between capital-intensive businesses and the rest to be crucial. For those numerous investors who use ROE to filter the castles from the shacks, they may be missing valuable investing opportunities. The lesson for the castle lover is clear—while the signs of some moats lurk on the balance sheet, not all do. Quantitative metrics will not uncover them all.

*[In the original post, I said “Joel Greenblatt’s Magic Formula screens for companies with the highest ROE and lowest earnings multiples (i.e., P/E).”  This was sloppy writing.  Greenblatt’s Magic Formula screens for high returns on capital (EBIT/net working capital+fixed assets).  ROE can give misleading numbers for companies with high debt or cash levels.]

Questions for eBay

Yesterday, reader and fellow blogger Eboro and I chatted over email about eBay, one of my favored wide moat businesses and the subject of a extended blog series.  In my view, Eboro’s observations and questions reflect the current majority view about eBay and highlight important worries.  With permission, I have edited and posted some of the conversation here.

EBORO: “Recently, I started going over [eBay’s] annual reports as well as well as using various models (FCFE, Relative, Expectations) to value the business. Although this is an important part of my process, I spend even more time “scuttle-buttin” to discover what the users (buyers, sellers etc…) think about the company. Although I only started my examination a month ago, I’ve spent hours on the eBay forums reading over thoughts and comments, as well as asking questions. Out of interest, have you done this?”

WIDE MOAT: Yes, I’ve done this and have been impressed by the indiscriminate vitriol toward eBay.  In general, I’ve found seemingly impartial assessments criticized as dishonest and meritless.  Any critique becomes an invitation for a new chorus of boos.  This article at SeekingAlpha and the comments strike me as standard fare.  Or, see this WSJ blog post.  My impression is that there is a significant group of former sellers that are very upset with recent changes.  It’s almost as if they feel personally violated in some way.  Rather than quietly take their business elsewhere, they want others to know that they have been (morally?) wronged, and eBay’s management are fools.  Really, very odd…

EBORO: “I only ask because it was during this process that I realized something was not quite right at eBay: buyers and sellers were complaining, in huge numbers, about the business; literally thousands of sellers are leaving the site. It seems as though this could have a negative effect on one of the key elements of eBay’s moat: its network. In my opinion, eBay’s growth potential relies heavily on the following: buyers come to eBay because they know that there are an abundance of sellers; sellers come to eBay because they know there are an abundance of buyers. Buyers don’t find the selection they used to, they don’t find the low prices they used to, and eventually, they start leaving.  What happens when there is a reduction in the number and type of sellers? … What I’m focusing on is the future trend for users: is management suffering from “confirmation bias” or “overconfidence bias”, by blaming all their problems on the macro-economy, as opposed to their decisions? Have they tried to focus on elements that they have control over (such as user experience, fees etc.) to try and improve?”

WIDE MOAT: I agree with your observations.  Many sellers have left and are leaving.  Though I would note that new sellers are joining up as well.  If there were a significant and sustained reduction in the total number of buyers and sellers at eBay, I would be increasingly worried about its auction business, so that is something that I definitely want to watch closely.  Any data on this would welcome.

I know some sellers who did a lot of business with eBay and have left to sell from their own websites.  This is smart business decision and should be expected.  If sellers don’t need eBay to drive traffic and sales, then eBay won’t have much to offer.

I know other sellers who were upset by the fee increases.  Pricing is tricky.  When you are in the dominate market position, you want your fees to be as high as you can get them, without going too far.  There will always be cheaper alternatives–e.g., Craigslist, OnlineAuction.com, etc.  Those competitors have to offer something that eBay does not, and without traffic, they have to offer a lower price.  Again, this is something that I want to watch carefully.  If eBay drives off too many sellers with high prices, they will eventually have to cut fees to reverse the trend, and that is a time-consuming process.

My own view is that management is too brash and too insular, and their record of acquisitions is spotty.  In the end, I would like to see new management in place.  However, and I say this over and over–even while receiving repeated and dismissive scoffs–there are incentives in place for current management to change, or for them to be replaced.  If the stock continues to trade where it is, with options under water, and the company so cheap, eventually the numbers have to hit someone on the head.  The stock price is screaming that there are problems, and that, I’ve found, is typically one of the most effective generators of corporate change.  Now, I’m not saying that change is imminent, but I know of no other mechanism that consistently propels change like a low stock price.

EBORO: “On paper, eBay is indeed extremely cheap, and they indeed own a variety of businesses that have various moats in place. As you well know, however, having stellar management that is responsive to change is just as important as the moat. eBay’s management, in my opinion, does not posses the necessary qualities. It seems as though Omidiyar may have made a mistake in hiring Donahoe. Although his CV is indeed impressive, that does not mean that he has the temperament and character to run this type of business. In fact, he has no experience in the industry whatsoever: he spent years in the consulting business, which as you know, is great at getting huge fees but not as good at providing tangible results. The changes he has put into place have begun to have a serious negative effects on the core part of the business. He’s running the business like a consultant, and not like a business owner and user. They can blame the macro-economy if they so choose, but the question then becomes, why did Amazon (a somewhat similar business) have their strongest quarter to date in such a bad economic period?”

WIDE MOAT: His performance thusfar suggests that he cannot do the job well.  Blaming the macro economy is embarassing; a competent CEO focuses on things they can control, defines relevant metrics for evaluating success, and then does the job.  Currently Donahoe seems obsessed with “buyer safety” and making an eBay purchase as reliable as a Wal-mart purchase.  I haven’t see enough data to show me that this should be his primary concern, nor have I seen data showing that his changes have been successful.  So, I agree, Omidiyar may have made a mistake with Donahoe.

EBORO: “The reason, for me, is self evident: Bezos and Amazon focus on their customers and their customers wants/needs, as opposed to their competitors, and their competitors’ actions. As Bezos has pointed out: “we set our strategy around what we perceive are the big customer needs, and we know that what customers really want is stable over time. If you base your business strategy on things that are going to change, then you have to constantly change your strategy, whereas if you formulate your strategy around customer needs, those tend to be stable in time.” This is the type of CEO I want when I’m thinking of investing in a business…”

WIDE MOAT: At the risk of sounding like a cynic, I would first say that Bezos uses his golden tongue well.  And at some level, he’s right; you have to serve your customers’ needs to have any business at all.  But saying it so simplistically masks the complexities involved.  I suspect that what customers really would want are lower seller fees, better inventory, and better service.  These needs are costly for Amazon.  So the truth of the matter is that there always has to be a balance struck between buyers, sellers, Amazon’s shareholders, and management.  Signs suggest that they have struck a good balance with their current strategy, and the stock price reflects that.  It could always go higher, but I see more risk to the downside than potential gain to the upside.

EBORO: “This is not to say that examining your competitors is not important, but when you neglect the very people who make up the “network moat” that your business enjoys, you stand to seriously harm the fundamentals of your business. It seems as though eBay has been trying to imitate Amazon, at the expense of its customer’s needs. Their customers want low fees (fees have seriously increased as of late, final value fees on Buy it Now are 12-15% on top of monthly fees and listing fees, they also introduced a minimum listing fee), they want a reliable bidding system (anonymous bidding allows for people to organize “fake” bids to help increase the prices of their products), they want excellent customer support (you should read the eBay boards to see how people feel about this; it’s not good) they want reliable, cheap and fast shipping (eBay has set maximum fees and shipping costs) and they also want reliable and easy payment methods (eBay has removed money orders and checks etc… and leaves paypal as the only option, which has caused huge negative feedback from users).”

WIDE MOAT: To extend on my previous point, yes, customers want everything.  In my experience, eBay’s customer service happens almost wholly on the Paypal side.  As a buyer, I have had some instances of fraud on big ticket items, and I did have to make a phone call, but refunds were quickly forthcoming.  I like their dispute resolution mechanism, since it gives the buyer and seller a lot of time and opportunity to reconcile without eBay and Paypal getting involved.  In terms of Paypal’s resources, you do NOT want to be getting involved as Judge Judy in all of these little spats until it is absolutely necessary.  So, if people want eBay to immediately resolve everything in their favor, I see that as unsurprising, but relatively juvenile.

And there’s the rub.  In most “problem” transactions, one party is going to feel like they got a raw deal, so after every such transaction, you created someone who can potentially go on an Internet forum and complain.  With million of transactions, a lot of people will have reasons to be angry.  I’ve had some bad transactions there myself, but you try to resolve it, leave negative feedback, and live on; it’s the buyer or seller’s fault, not eBay’s.  I see eBay’s marketplace a little like the Wild West in that respect, and most buyers seem willing to accept that.  And like I’ve said, I’ve never had a problem getting a full refund with Paypal’s buyer protection policy, so the risks seem relatively low.

EBORO: “Amazon tried imitating eBay years ago, but this didn’t work, so they stopped (instead, they launched something similar, but different: their “third party retailer” business. This isn’t an auction type business, it’s simply a “used items” business. It’s working very well thus far). The point that I’m focusing on is the fact that Bezos truly understands his business, loves the business and it’s customers, and does everything in his power to be innovative and adaptable to demands – there’s a huge incentive for him to do so, as he owns 23% of the company. Donahue simply doesn’t seem to grasp this yet, and until he does, I can’t see myself buying into the company. I’d at least like to see him acknowledge this, and begin making the changes that will make users happy. This is the key part of this business, and buy catering to larger power sellers, at the expense of others, they may get larger sales for the huge volume sellers, but will lose the variety and diversity the smaller ones bring.

It’s interesting to note that the success of an investment is as much about the actual value of the business as it is about the speculative value of the business. Until others eventually agree with an analysis, the investment cannot be successful. It’s possible that many investors will continue to shy away from Ebay shares until their core business adapts to it’s customers and starts growing again. These, in my opinion, are the best bargains one can get: when management has already realized that changes need to be made, and are moving in this direction, and yet the market doesn’t price this in yet at all. A simple example of this would be Apple. The shares were a great buy at $15 in 2004, simply because you could see what Jobs was doing, and thought: he’s got it right, he’s bringing back the “style” that made Apple so successful to begin with, he’s got excellent products in the pipeline (that people clearly want), he provides a one of a kind “experience” with a very innovative platform (OSX) and he’s listened to customer wants/needs; and yet, the market isn’t pricing this in at all yet.”

WIDE MOAT: It strikes me that your last points are more about market timing.  And you may be absolutely right.  Perhaps pessimism surrounding eBay could increase.  Perhaps we’ll see evidence that management is changing its plan.  Perhaps then we’ll have the ideal opportunity to buy.  It definitely would be a better investment if new management were in place, with a smart plan, and the stock still trading at these levels.  I just don’t have the confidence that the stars will all align in this way.  Or, that I’ll be able to enter the stock at the most opportune time.

I like your assessment of what it takes for an investment to appreciate in price.  If you are buying a share of a business, rather than the whole business, then yes, you have to get other people to agree with your assessment of a business’ value in order to sell.  So when I buy, one strategy is to be a contrarian, and find a decent business inundated with pessimism.  Most of the time, of course, the pessimism is warranted, and the company’s problems intractable.  Here I don’t think that is the case.

The worst case scenario that I foresee is eBay continuing to lose GMV, beginning to lose users, seeing cash flows decline while expenses stay high, and the stock price continuing to fall.  Then the company gets taken out by Microsoft, or Yahoo, or someone else, at a lower price than I paid.  It is a risk, and it is possible.  It’s hard for me to imagine the stock price going much lower without someone buying the whole thing, but it could.  If I had 17 billion, I would have my unsolicited offer at their door by Monday morning.

Thanks for the questions, Eboro.  It’s been fun.

Disclosure: I, or persons whose accounts I manage, own shares of eBay at the time of this writing.