Some New Ideas – July 2015

This year continues to be a bit of a struggle for me mentally because I know how much we have risen over the past 6 years, so I’ve been looking to take gains when I get them.  Unfortunately, it has left me pretty skittish and at times unable to properly assess risk / reward like I did in the past because I feel like I’ve had one foot out of the door waiting for the inevitable drop to come.  I’m assuming a lot of people are in the same boat that I’m in because stocks seem to be flip flopping all over the place all year, with very little price memory from one day to the next.

Anyway, figured I’d talk about a few new opportunities I’ve found: some that I’ll hopefully hold for longer than a few days / weeks.

Regional Financials:

There is a big move by the larger regional banks to take out smaller banks as the smaller banks are struggling to generate significant profits in light of increased governmental regulation.  I don’t think this trend will end, so I’ve been looking to get exposure to small regional banks that are trading at under 0.90x Book.   Back in 2006-7, banks were trading at around 2x Book, by comparison.  I don’t expect a return to those valuations anytime soon, but I have seen a lot of small banks getting bought out for around 1.2 to 1.3x book recently.

With all of these I’m trying to avoid exposure to energy markets (i.e., banks whose customer base is primarily energy related) as oil is down 55% and doesn’t look to be rebounding any time soon.

I bought some $KTHN, a tiny bank up in Maine, at $11.50.  With a market cap of $39 Million, they’re trading at about 0.65x Book Value (ie Net Equity), which is a pretty steep discount to most publicly traded banks.  It’s also trading at about 9.3x annualized EPS from last quarter and earnings grew about 30% last quarter.  The average microcap regional bank is trading around 14-15x EPS.  Below is a snap shot of its most recent earnings report:

Screen Shot 2015-07-30 at 12.20.20 PM

Another bank I bought is $FSFG.  It’s a little more expensive than $KTHN relative to book and EPS at 0.7 p/b and 11 p/e, respectively.  FSFG is based out of Indiana.

Investing in India

I feel like I have a pretty good knowledge of how important it is to become the leader in any particular internet space, having run a few internet sites over the past 15 years.  So I am always on the lookout for companies in the Internet space.  It is very hard for the 2nd/3rd tier players to acquire traffic to take over the leader.  Organic traffic from search engines is extremely valuable and having a leadership position becomes more and more difficult to overcome over time.  Once a leader is established in a particular internet space (i.e shopping, search engines, travel, etc), that leader starts exhibiting strong network effects that reinforce the value of that site to its visitors.

As the market has gone higher over the past 6 years, it has become harder and harder to find growth that isn’t already priced at extreme levels in the internet space.  I have had a lot of success over the years investing in internet related companies, with MySpace back in 2005 (the precursor to $FB), $BIDU in 2006, $Z in 2012 and a handful of others.  While growth in internet penetration is slowing down globally and valuations are pretty high in the majority of the biggest players like $GOOGL $AMZN $FB $BABA $BIDU etc, there are still opportunities in some international markets where internet penetration is still low.  Particularly, India comes to mind.

Mary Meeker recently highlighted India in her latest State of the Internet 2015 report, and Jeff Gundlach was recently interviewed on CNBC where he talked at length about India.  Here is a portion of his comments:

“Yeah. I’m really quite bullish long-term on India. In fact, I’m like a 10 on a scale of 1 to 10 bullish on Indian equities for the next generation.

What happens next month, I have no idea. Year to date, it’s been pretty sleepy, although last year they killed it. And the reason is basically a demographic reason.

One of the reasons China had such an incredible economic performance over the last generation is they had a couple hundred million people entering the labor force, and they also made some reforms and they took some of the glue out of the gears in the economy.

Well, India is in that same position. There will be a couple hundred million people entering the labor force in India and they have plenty of room for improvement when it comes to the legal system, the cronyism and all this. When I mention Indian equity market, people bring out these negatives. And I say, well, that means there’s room for improvement.

Early in my career I was having lunch with Howard Marks. I was sitting there and I said, you know what, Howard, I don’t understand why anybody ever buys a AAA-rated corporate bond because they can only go one way, right. They can only go down.

And so markets that have problems generally have some sort of discount built in to them.

So I believe that if you are going to — I was speaking and a guy came up to me, he was like 24 years old, what should I buy and not touch it, I have a 50-year horizon. I said I would buy the Indian stock market.”

India has seen a significant ramp in GDP growth recently due to new leadership coming in that is pro business, internet penetration rates rising substantially (yet still at only 19% of total population), excellent demographics (More than 50% of its population is below the age of 25 and more than 65% is below the age of 35), and low oil (India imports about 80% of its supply).  So lots of positives working for India in the longer term.  Here is a look at recent growth in GDP in India:

Screen Shot 2015-07-30 at 1.33.15 PM

Inflation had been pretty aggressive the past few years but that has fallen quite a bit as their currency has stabilized and oil prices have gone down, and as a result GDP is now rising about 8% annually, the fastest in the world amongst countries with a GDP above $1 Trillion.

Per a report from KPMG, 905 million Indians live in rural areas and only 6.7 percent, or 61 million, currently use the Internet on a regular basis.  The urban areas have seen pretty high internet usage rates, but the majority of internet users are on 2G networks with very slow connections (think AOL dialup in the mid 1990s in the US).  At the end of 2014, there were 82 million 3G subscribers in India, but that number is expected to almost triple to 284 million by the end of 2017.  If you put this into context, only 6% of its population is using 3G.  Compare this to a nearly 50% penetration rate of 3G or 4G users in China.

Below is a great chart from Mary Meeker’s report highlighting the inflection point that India is at with regards to internet penetration, comparing where it is now with where China was in 2008 and where the US was in 1996.  She makes the point that now is the time to be looking for those catalyst companies in India being shaped by this inflection point, much like Tencent ($TCEHY) and Alibaba ($BABA) in China and $AMZN $EBAY and $YHOO in the US at their respective inflection points.

Mery-Meeker_India_State_of_the_Internet-YourStory-2-1024x768

Anyway, you get the point: India is growing fast, its middle class is growing rapidly, internet penetration rates are exploding and yet it still has a ton of room to grow.  Great long term tailwinds for investors in India.  With this in mind, I took a look at the companies that are most likely to benefit from growing trends in India.  My strategy is to avoid 2nd tier companies like $REDF because of how difficult it is to compete against market leaders, and to focus on areas that would see direct benefit from a rapidly growing middle class with extra disposable income and that would benefit directly from increasing mobile usage.  The obvious play in my mind is Makemytrip ($MMYT), the Expedia ($EXPE) of India.

Makemytrip

$MMYT came public in 2011 and has seen dismal performance for its stock.  They IPO’d at $22 and ran up to $42 within the first few months.  The stock is currently trading at $15.59, down 19% today on a weak Fiscal 2016 Q1 earnings report.  The report was pretty ugly…marginal top line revenue growth below forecast, with an earnings miss and a below estimate guidance for the year.  Not exactly what you would expect when you see internet usage and growth in domestic flights exploding.

I think the headline #’s mask what is really going on, though.  The problem they’re dealing with is three-fold:

(1) There’s a mad scramble right now to gain market share as new competitors are coming into the market, at the expense of revenues and earnings.

(2) Currency fluctuations are impacting net revenues.

(3) Net transaction values have been decreasing on flights as airlines have been engaged in pricing wars to acquire customers, which reduces total revenues to MMYT.

Here is a look at the ugly headline #’s:

Screen Shot 2015-07-30 at 2.42.24 PM

Revenue less service costs (ie the margin they make on each transaction) only grew 7.5% (made up of 10.8% growth in air travel and 2.8% growth in hotels and packages).  Not exactly explosive growth.  But if you drill down a little more to the actual transactions occurring on their network (i.e., Makemytrip.com and on their mobile app), growth looks much better and more in line with growth in internet usage and domestic travel:

Screen Shot 2015-07-30 at 2.44.14 PM

The number of transactions for airline tickets grew 45.6% and for hotels and packages the number of transactions grew 27.6% when excluding a transaction they made last year.  And if you drill the latter figure down to just hotels (I’ll explain later) then you will see 78.1% growth year on year.

I believe the discrepancy between the headline #’s and these transaction figures is due to MMYT’s decision to gain market share at all costs…ie. getting as many hotels as possible on their network so they can increase the # of offerings to their customers, even if it means charging lower fees to the hotel.  This is the exact same game that $AMZN has played for the past 20 years as they gain market share at the expense of profits.

I’m not sure if this decision is a reaction to competitors trying to negotiate lower rates with hotels or if MMYT is proactively trying to squeeze out competitors.  Given MMYT management’s recent comments, my guess is its more of the latter:

“As we begin the new fiscal 2016, we believe we are on the cusp of a second wave of internet penetration driven by unprecedented smartphone penetration which is helping drive online booking behavior in the strategic India standalone hotels segment. We were able to leverage our investments on the mobile channel and in the hotels segment to drive 78% transaction growth in India standalone online hotels fueled by over 200% growth on transactions coming from mobile channel during this quarter” said Deep Kalra, Group Chairman and Group CEO. “This makes us believe that it’s the right time for us to single mindedly focus on accelerating transaction growth in the Hotels and Packages business to grow our market share in this strategic segment with a view of consolidating long term market leadership in the OTA space.”

Unfortunately, MMYT hasn’t released data on the standalone hotel transactions until this past quarter, so I can’t see the trends in those numbers.  The growth in hotels and packages transactions has been decelerating in recent quarters as shown below:

Screen Shot 2015-07-30 at 3.02.08 PM

Growth in the H&P segment has gone from 106% > 70.9% > 46.6% > 32.2% > 27.6% over the past 5 quarters.  Still very solid #’s but the trend is slowing down.  To get a sense of what’s going on, management’s disclosure that hotel transaction growth this quarter was 78% implied that customers are booking less packages.  On their Q1 2016 call, management made some comments about seeing customers’ preferences to only book hotels versus packages recently, which has resulted in lower gross bookings and thus lower revenues per transaction:

“However, the deceleration in hotel packages and international online hotels reduced overall hotel packages transaction growth.  Increasing customer preference to buy standalone airline tickets and hotels has resulted in average transaction value decreasing by 13.5% and gross bookings remain almost unchanged on a year on year basis.”

Conversely, airline transactions growth has been accelerating, from 16.1% > 45.6% over the past 5 quarters.  The net revenue coming from this segment was up 10.8%.  The discrepancy between the 45% transaction growth and 11% revenue growth was caused by currency fluctuations and lower average transaction values as airlines are engaging in price wars to gain customers.

With about $150 Million in net cash (cash and term deposits), the balance sheet is pretty strong.

Airline Traffic in India

Growth in domestic travel in India has been a major catalyst for growth in air ticketing transactions as they are directly correlated.  MMYT air ticketing transaction growth has been roughly doubling the domestic travel growth for the past 3 years:
2013: Indian domestic travel growth: +4.45%, MMYT transaction growth +9.3%
2014: Indian domestic travel growth: +9.24%, MMYT transaction growth +15.24%
Q1 2015: Indian domestic travel growth: +20.9%, MMYT transaction growth +39.8%

Q2 2015: Indian domestic travel growth: 18.5%, MMYT transaction growth 45.6%

With transaction growth nearly double the growth of domestic travel growth in India, MMYT is expanding its already 40% market share of online travel (latter figure disclosed by MMYT last quarter):

Screen Shot 2015-07-30 at 3.37.30 PM

To get a sense for what kind of growth the travel market might have in store in India, its best to look at China and the US as guides.  In the US, the average person flies roughly 1 time every 5 months.  In China, the average person flies roughly 1 time every 3.5 years.  In India, the average person flies 1 time every 20 years.  In order to get to the current averages in China, India would see its travel market grow 6-fold and to get to current averages in the US, it would see its travel market growth 48-fold.

Conclusion

This reminds me a lot of Ctrip.com (CTRP), the leading online travel agent in China.  In 2005, $CTRP had a market cap of about $600 Million.  10 years later CTRP revenues are up 20-fold from $65 Million to $1.3 Billion while domestic flights in China are up from 70-80 million to over 400 million annually.  CTRP’s stock is up 1300%.

Right now, India is on pace for about 75 to 80 million domestic flights, up from about 25 million in 2006, and growing about 20% annually right now.  I believe MMYT is going through the same thing CTRP went through in 2012.  In 2012, CTRP’s stock was down from $50 to $12 – 13 on fears of competition impacting revenues and earnings.  At its low the stock traded at around 3.5 – 4x Trailing Twelve Months Revenues.  CTRP shifted its focus to maintaining / gaining market share and while operating income dropped from $203 Million in 2011 to -$27M in the past 12 months, the stock has soared from $13 to $70+.

Similar to CTRP, MMYT has shifted its focus away from net income toward maintaining / gaining market share.  Management guided 50% to 55% transaction growth in hotels and packages and air ticketing transaction growth has been running near 40% recently.  I believe within 12 to 18 months we should see a much higher price for MMYT.

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