Friday File: “Mysterious M-Boxes” and more

by Travis Johnson, Stock Gumshoe | March 8, 2019 4:09 pm

Checking out a Nova-X teaser, plus updates on Nokia, Facebook, Fairfax India and more...

Since I added to a telecom/5G stock today, and I see that same stock being teased again this week, I thought I’d take this Friday opportunity to solve a teaser for you as I update you on my portfolio moves.

The teaser is from Michael Robinson for his Nova-X Report ($79/year), and it sounds kind of familiar….

These Mysterious ‘M-Boxes’ – Hidden in Your Neighborhood – Are About to Spark a $12 Trillion 5G Cash Rush…

The ad is pretty similar to the “Weird New Antennas” pitch from Jeff Brown at Bonner & Partners last year[1], also about 5G and the big wave of investment there will be as these 5G stations are installed around the world… largely because 5G, in order to work effectively, has to have antennas much closer to users than 4G/LTE — they can’t rely just on towers or a few big collections of centrally located base stations, they need to have a “M-Box” every block or so in urban areas.

More from the ad:

“And make no mistake: Inside this box is the most important new technology to be created in decades – capable of completely changing life as we know it.
I’m talking about 5G, of course.

“And it could also change your financial life in ways most people only dream about.

“Millionaire status?

“You might want to start thinking bigger…

“A whole lot bigger…

“I wouldn’t be surprised if these little black boxes created the world’s first TRILLIONAIRE!”

There’s a lot of chatter about 5G bringing forth the “fourth industrial revolution,” as well, and I’m sure you’ve heard a lot about that before — I won’t bore you with a huge spiel, but it’s basically that 5G will offer a combination of much faster transmission speeds that can move dramatically more data, and also that the latency will be so low that you can have essentially real-time interactions and decisionmaking by machines… so 5G makes all the dreams of robust “Internet of Things” interconnected machines more feasible, it could power driverless cars, etc. etc.

More hype:

“And these little “M-Boxes” I’ve been telling you about…

“They’re creating a 5G world, right now as we speak.

“The network that will make EVERYTHING possible is forming right before our very eyes….

“… these little “M-Boxes” are like “super-connectors” – they are the foundation upon which the new world will stand…

“Imagine a world-renowned surgeon in Los Angeles… performing emergency brain surgery on an accident victim… while the patient is still in the ambulance… on the Pennsylvania Turnpike… over 3,000 miles away!”

Then we get into some specific hints about the “M-Box” company he’s teasing:

“… a lot of big companies – including AT&T, Verizon, and Comcast – are going full force into 5G.

“Now, you can go ahead and invest in those companies right now, if you like.

“It’s a safe bet you’ll make a decent return.

“But there’s one company I want to introduce you to that’s completely under the radar.

“But it has the potential to make you exceedingly wealthy.

“Right now it’s criminally undervalued. Shares are up for grabs for just $6 a pop!

“Heck, that could be the deal of the decade right there…”

Hmmm…. might this be the same stock as Jeff Brown’s pitched “$6 Digital King?[2]” Let’s see if we get some other clues…

“… this one company has a specific technology that is an essential requirement for making 5G work the world over.”

OK, note that he didn’t say “exclusive” … but “essential” is pretty good. What else?

“… the bleeding-edge tech INSIDE these mysterious “M-Boxes” is absolutely fascinating, if a little complex.

“They Shoot LASER-Like Beams Precisely Where They Need to Go…

“These boxes leverage high-gain, adaptive antenna technology and sophisticated best-path-selection algorithms.

“They are powered by something called MU-MIMO 802.11ax – which stands for multiple user, multiple input, and multiple output antennas.”

What else? Here’s some more squishy hinting from the ad:

“This company is better positioned than ANYONE to skyrocket as 5G lifts off.

“To say it’s in the catbird’s seat would be an understatement of epic proportions.

“You see, this $6 company is totally rare and unique.

“For the last decade, they’ve been strategically positioning themselves to take FULL advantage of the 5G revolution.”

What else?

“This $6 company is a unique hybrid. It offers both the rock-solid stability of a proven blue chip and the upside profit potential of a small-cap startup.

“I’m almost certain that you will have heard of this company.

“This isn’t some backwater stock with dodgy financials.

“They have a long history of pioneering tech advancements.

“But for the last few years, they’ve almost completely disappeared from the public spotlight.”

And then they drop a bunch of hints about the locations of the companies offices, factories and projects and partnerships around the world, summing up a few things here:

“And recently, one of their top executives revealed they’re involved in more than 70 separate 5G-related projects!

“I realize this is not the kind of MASSIVE GLOBAL EXPANSION you associate with a $6 company.

“But this is NOT your ordinary $6 company.

“Already, savvy institutions – including BlackRock, Goldman Sachs, and JPMorgan – have grabbed 225 million of the available shares…

“Their year-on-year growth for 2017-18 is an incredible 782%…

“And in 2021, I project sales could be boosted by a staggering, mind-blowing, $35 billion.”

We get two “move fast” pushes in the ad as well — the first being that “a brand-new, 5G-related product is expected imminently.” and thesecond that “one of this company’s biggest 5G rivals has just been BANNED by the U.S. and others.”

I don’t know which 5G-related product he’s hinting about, but likely the biggest splash in 5G in the US this year will come from the introduction of Samsung’s 5G phone, the Galaxy S10 that is expected to launch in thenext few months, along maybe with a Samsung folding phone that they hope will take some luster from Apple, which probably won’t release a 5G iPhone until 2020 at the earliest (Apple doesn’t tend to focus on being first, and there’s going to be so little 5G coverage this year that it won’t make a big difference to most customers… but it could give Samsung an edge in marketing, at least).

The “rival” bit is obviously about Huawei, which is the driver of so much of 5G talk right now — the Chinese company that has come essentially from nowhere to dominate telecom infrastructure equipment in the past decade, with low costs and more rapid technology advancements than pioneers like Nokia, Motorola and Ericsson.

And yes, there’s still some room for being wrong on this given the lack of completely perfect clues, but I’m quite sure that Michael Robinson here is joining Jeff Brown in promoting Nokia (NOK) as a 5G investment.

Which I agree with, by the way, though I think there’s no chance that it will return 10X your money anytime soon. And no, Nokia does not have a “lock” on 5G equipment or base stations or antennae — they will be built by lots of companies using similar technologies and agreed-upon global standards, though Nokia is a leader (and does have some patented and unique products, both on the handset end and the network end, and will receive some royalties from other equipment makers as well, as most of the leading companies will).

Nokia (NOK) has edged toward “cheap” again of late. They are keeping the deal flow going, the stock is well off the highs, and it still yields almost 4%, despite a growing presence in these early stages of 5G network building. Huawei’s fate as the global leader in most mobile telecom network equipment (Nokia is arguably in second place, though Samsung and Ericsson might dispute that) is still a big unknown, but the uncertainty over Huawei is certainly giving Nokia (and Ericsson, and Motorola, and Samsung… among others) the opportunity to catch up with their dominant Chinese competitor, though I continue to read that Nokia has a broader and more complete network offering than anyone else other than Huawei.

If analysts are at all right in their forecasting (and they might not be, of course, but their guesses are definitely more informed than mine), then 2020 is going to be the huge bump-up growth year for NOK revenues and earnings — the estimate is that NOK will have earnings of 32 cents per share in 2019, growing 40% to 45 cents in 2020, and that assumes a shift to higher-margin sales because overall revenues are only projected to grow about 2% a year, from $25.9 billion in 2018 to $26.9 billion in 2020.

The stock is trading at just under 19X 2019 earnings forecasts and 13X 2020, so it’s not dirt cheap but it’s certainly trading at a low valuation IF they can grow earnings anywhere near that quickly… and while they may indeed disappoint, this is a huge business that will not disappear overnight, and it trades at only a little over 1X sales so there is ample room for improving the valuation if sentiment shifts in their favor.

My guess is that the shares will have a strong second half of 2019 as we edge toward the much more intensive 5G investment wave that’s expected in 2020, and that’s why I’ve been building a position… but that, of course, is a guess — a lot depends on the financial health of the telecom companies around the world, the pace of telecom infrastructure investment, and the state of global trade (to say nothing of competition from Huawai and how that shakes out). 5G will not be an instant change to the world, the rollout of the technology is going to take a long time… but all indications are that yes, the rollout is going to be a very big deal for most of the telecom infrastructure companies.

Much of my thesis is based on the fact that NOK is well-positioned to win contracts for 5G infrastructure buildout projects, and is already doing so, but they also have a strong existing business that provides some stability, and they remain a core equipment provider for hundreds of telecom and tech companies around the world in both mobile and wired networks, including the continuing buildout of 4G/LTE in many countries. They are certainly subject to competition and won’t always be the technology leader, but they do have a wide product portfolio and they are not going to lose every competitive bid. They are small enough, relative to the size of the market opportunity, to grow very rapidly, particularly if the pace of 5G investment heats up… but they’re also large enough and boring enough to be ignored by most investors who still see them as a handset maker or dinosaur.

So as it dips below $6 and trades at 19X earnings, with a near-4% dividend and the tailwind of what will probably be a decade-long infrastructure build for 5G after a long slow slog of reorganizing a pioneering company, I like letting Nokia become a larger part of my portfolio. I bought more today.

*****

Other news?

iQiyi bearish article titled “The Netflix of China Might Just Be Wishful Thinking” in Barron’s[3] with “at most” $17 price target… mostly because the analyst models subscriber growth slowing dramatically in a few years, price competition among the big three (plus others) that will make it hard to raise prices, production/content costs that are rising, and advertising revenue dropping in importance because paid subscriptions are rising. And unlike the US, traditional cable TV/paid TV is inexpensive in China, similarly priced to the online video services, so “cord cutting” is not a major financial driver.

That’s one possible future, of course, but it presumes that the only viable model to compare to is Netflix… and that three online video providers can’t all succeed, but that they will destroy each other in the process. That’s why I have kept my IQ position fairly small, but I do still see it as advantaged versus Youkou Tudou (Alibaba) and Tencent Video so I’m willing to keep speculating that IQ will have the hits to get itself most established first. It’s certainly high risk, and the financials do not make sense yet for a $20 billion company, but it’s also a truly massive market so I think there’s meaningful upside potential here as well. As we’ve seen this week, all of the China stocks are essentially moving together as they are influenced much more by the “will they/won’t they” trade negotiations and the big-picture Chinese growth fears, so I’m expecting plenty of volatility… but with a small position, I can handle it.

****
Fairfax India (FIH-U.TO, FFXDF) now trades at almost a 10% discount to book value, though their investee company IIFL has dropped considerably since the end of December so book value might have fallen by the time we get our next quarterly update (Fairchem, the only other meaningful publicly traded stock in the portfolio, has risen nicely, but is not big enough to make up for IIFL’s loss). The value of the private investments is, of course, largely a made-up number that doesn’t have a meaning precise enough to count on… though I continue to believe that their majority stake in the Bangalore Airport has a good chance of being worth more than the whole company over the next 3-5 years as expansion projects begin to generate fruit (they are adding a runway and expanding the terminal).

There is plenty of risk, much of it tied to Indian politics and the direction of the Indian economy and currency… but the risk that India will back away from Modi’s attempted economic reforms seems lessened now that he has embraced the latest conflict in Kashmir to ramp up India’s military response to Pakistan. War and nationalism are great electoral motivators, and seem in this case to be playing to PM Modi’s strengths… though, of course, that could change quickly. I think the risk of a big election shakeup has been reduced a bit, and I increased my Fairfax India position by about 10% today.

*****

Ligand Pharmaceuticals (LGND), no longer in the Real Money Portfolio but stilla fascinating story for me, announced a bombshell this week, they’re selling Promacta to Royalty Pharma for $827 million… a phenomenally huge deal to offload what is by far Ligand’s most valuable asset.

That gives Ligand a ton of cash to make its next deal, but it also means they are losing a huge chunk of their anticipated annual revenue and earnings… and it’s the chunk that was arguably most reliable and most predictable. They were expecting over $100 million in Promacta royalties this year, and that number could have doubled over the next few years with some new approvals and continued strong sales by Novartis, but Promacta did have a coming wave of patent expirations from 2021-2028 that was likely starting to concern investors a little, and that brought some uncertainty about when that royalty might begin to dwindle, either from competitive pressure with new products in the space or from the eventual introduction of generics… so this gets rid of that worry.

It’s going to be an interesting story again, and it does require a complete reset in thinking about the company.

What value, then, do we place on Ligand as a company that’s out looking for royalties and platforms but doesn’t have meaningful cash flow of its own? I guess that depends in part on whether they shrink the company with massive buybacks, as they now could with their billion-plus cash pile, or whether they really try to grow with acquisitions, which can be dicy (and, as we’ve seen with this sale, there are other companies out there angling to buy royalties so the good ones won’t be cheap).

And, of course, there’s also the convertible bond still to deal with — I don’t know whether this sale impacts the debt agreements or not, perhaps they’ll mention it on the conference call, but that’s certainly possible (either way, they still have huge flexibility, with almost a billion in net cash even if they either retire the debt in cash or buy back any dilution from the conversion of the debt). This sale of Promacta also uses up Ligand’s tax loss carry-forwards, so they won’t pay much in taxes on the sale but they will become a regular tax-paying company going forward.

But boy, what an asset they’re losing. This is no longer an earnings or revenue story, nor a royalty growth story, it’s a “find new royalties” story — and that’s a science and deal-making story, which means the possible outcomes are legion and you have to trust the management to make the right deals (and probably get a little lucky as well). The CEO is still John Higgins, the same guy who was brought in to reshape Ligand (by Dan Loeb) when it was still a free-spending biotech R&D company that was hemorrhaging cash, and he was in charge when they made the foundational deal to buy the maker of Captisol and license it out to drugmakers to generate potential future royalties… which led, most importantly, to Ligand’s second largest royalty, on Amgen’s Captisol-enabled Kyprolis.

But beyond the approval of Kyprolis and the growth in sales of that drug and, more importantly, the incredible growth in Promacta royalties over the years, which surged higher still as new indications were approved, and particularly when Promacta was sold by GlaxoSmithKline to Novartis a couple years ago and got a marketing kick in the butt, they haven’t really generated anything financially meaningful other than more of what Higgins likes to call “shots on goal.” Promacta was discovered years earlier, in a research collaboration between Promacta and GlaxoSmithKline in the 1990s (it was submitted for FDA approval in late 2007 and was approved for its first indication in November of 2008, with several much larger indications added over the past decade), so Higgins was the CEO when Promacta was approved but not when the research collaboration was in place or the deal was initiated.

So this is a doozy, indeed, what do you do when a company sells its trophy asset in order to do more of what it has so far been unsuccessful at, at least in short-term financial terms, over the past seven years? The lack of success is partly relative (Promacta was a drug they had a hand in discovering back when they were a free-spending biotech company, not just one they got a passive royalty on because the developer used Captisol or one of Ligand’s other patented discovery tools or delivery methods, so the royalty was FAR larger than average)… and is not specifically Ligand’s fault, the high failure rate and long timeline are ubiquitous for drug developers, not a failing of a particular company.

Ligand’s strategy of offloading all costs of development means the failures didn’t cost them much, either, so that’s good, and that’s the reason I initially bought shares back in 2013… but what will investors think now that this company enters year five or six of the search for a third major royalty? Particularly because it’s no longer that third royalty they’re looking for, but since they sold the lead dog it’s now a second meaningful royalty that they lack. Rapid revenue growth even from this new base level is no longer at all certain, particularly since Kyprolis is in a much more competitive market than Promacta was and pays a much smaller percentage royalty, and all of their near term royalty prospects are small… but it is possible, with a larger number of funded R&D programs leading to possible increases in milestone payments and, someday, more royalties… and man oh man do they have a lot of CASH now. Whatever will they do with it?

If investors give up wholesale, I might find myself getting back into Ligand… but if they like the idea of “Ligand with an extra billion dollars” more than they like the idea of “Ligand with $100+ million a year in Promacta royalties”, well, then I’ll probably still sit on the sidelines wondering whether they’ll ever get that next big royalty stream, and, since they will probably have to buy the next big royalty because there aren’t any really fat royalties to hope for in the near-term pipeline, how much it will cost them.

So far, the stock is down a bit and I’m still a non-investor (I sold my stake at an average price of $178 in two tranches as it fell, at $204 and $100), but if it gets cheap enough to make a bet on “what will they do with that money,” maybe I’ll buy back in — that would be considerably below today’s levels, I imagine, but my opinion could change. If you back out the cash, Ligand is now trading at about 10X sales… but they’ll be giving up their very best revenue growth driver and exchanging it for a much less-predictable possibility of future revenue growth. This is how they summed it up in the presentation (the emphasis is mine):

“EPS projected to be lower in the next few years without annual Promacta royalties offset by a major cash infusion from sale of Promacta rights. Long-term revenue and earnings expected to be higher following re-investment of Promacta proceeds.”

They have an analyst day next week, on March 12, so that will be the beginning of them trying to “reset” the company and get investors on board with looking at Ligand as a future growth story instead of as a current cash flow story (the presentation from the Promacta announcement is here[4], if you want a bit more detail).

*****

I want to share a couple negative sentiments with you today, too — should I sell Facebook or short Softbank? Those are two of the stronger urges I’ve had personally this week, though I haven’t acted on them yet, so I thought I’d share my thinking.

Is it time to sell Facebook (FB)?

The stock is back to a reasonable valuation now after last year’s collapse and the sharp recovery earlier this year, with still the risks of being the poster child for privacy violations, misinformation campaigns and screen addiction — with Mark Zuckerberg’s latest “privacy pledge” throwing the future into more question as he positions Facebook for a world of more private communication and less broadcasting of information, and essentially indicates that they’re going to remake Facebook based on a new business model (shifting the focus to Messenger and WhatsApp, really).

This is a big deal, open sharing creates massive networks and openness to new information, which really reinforces the power of advertising in that platform and enabled Facebook to grow to incredible size very quickly, but private networks are potentially far more limited in that way.

This is early days in that “privacy-focused vision,”[5] of course, and Facebook is not going to change that quickly — their core Facebook and Instagram product remains the best advertising platform for reaching very targeted people at relatively low cost for small businesses, I believe, and the money is likely to keep gushing in even as they begin to try to steer the ship in a new direction. I wouldn’t sell just because of this, but that does make me question the potential for continued network-effect gains for Instagram and Facebook.

The response of the investing punditry has been, “Facebook is trying to become WeChat” — and that would be the core reason for any investment-based optimism regarding this pivot, since Tencent has managed to build WeChat as basically the circulation system for all information in China, in some ways offering a replacement platform for email, payments, texting, gaming, shopping and so much more. If Facebook can create a transactional platform like WeChat out of Messenger and WhatsApp that helps to further cement them into the foundation of other businesses, then this could work out very well… if not, it will be expensive and will just take away from the massive Instagram/Facebook advertising platform.

I’m skeptical that it’s possible for a large company to build a product like that now, but if anyone can do it in the US it’s likely Facebook… even with their regulatory challenges.

So where do I come down now? When I last looked at Facebook it was very reasonably valued at $150 and particularly easy to buy at $130, given the incredible tsunami of cash that advertisers continue to throw at them… today, at $170? That’s not as easy. The stock trades at 22X forward earnings and has a ton of cash on the books ($41 billion, about $14 per share… though they didn’t add to their cash balance at all in 2018, thanks largely to big spending on more offices and data centers), so it’s not particularly expensive… and analysts still expect them to grow earnings at 15% a year or so for 2020 and 2021 (this year is penciled in as a slight drop in earnings because of Facebook’s massive spending spree, from $7.57 to $7.50 per share, though that may be too conservative as well). But it’s also a $500 billion company with essentially a single product (Facebook/Instagram advertising) and a very tarnished reputation that’s attracting more regulatory attention, and a CEO with super-voting shares who can do whatever he wants in terms of strategic direction.

By comparison, Alphabet (GOOG) is half again as large as Facebook, slightly more expensive (forward PE of 24, versus 22 for FB), and expected to grow earnings at about the same rate over the next couple years… but it is also a more consistent cash generator and has a much larger cash pile, even on a relative basis ($109 billion now, $156/share, growing even with similarly large investments last year), so if you back out the excess cash that both companies carry they both trade at 20X forward earnings.

I think Alphabet is a much safer and stronger company, with a much broader horizon of possible futures thanks to YouTube and Waymo and their many venture investments that have the potential, eventually, to help supplement their core dominant advertising network and operating systems. At current valuations for both, which both look pretty fair to me given their large size and the regulatory risks both face, I’d easily choose Alphabet over Facebook today… and, frankly, I think the likelihood is that the risk for Facebook is higher than I’ve guessed in the past — though that may just be a personal bias. I have found that taking a break from Facebook personally gives me a wash of well-being that greatly improves my personal life… but it would be hard for me to get through a day without using a Google service, and in the absence of free Google search I would happily pay a hefty subscription fee for access to such a miraculous trove of well-indexed information. Of course, without Facebook products the little Gumshoes would have to find a non-Instagram source to feed their meme addictions, so the next generation might not agree.

In the end I decided to just shave off a little bit more of my profit with a small sale, which roughly provided the cash for my additional buy in Nokia, and I’ll keep watching.

*****

How about shorting Softbank (SFTBY)? That would in some ways be a hedge against all of the richly-valued stuff in my portfolio, much of which will move similarly to Softbank’s wildly leveraged portfolio of unicorns… and also a hedge against rising rates, since Softbank, perhaps the most levered large company in the world that’s not a bank or asset owner, is going to be severely impacted if their cost of borrowing rises.

Softbank is a lot like Tesla (TSLA), in that it’s largely a bet on a visionary — but unlike Tesla, which has one identifiable business, Softbank is a hugely levered portfolio of venture investments and unprofitable telecom stocks, with massive outside money in their Vision Fund helping to make Masayoshi Son appear to be an extremely undisciplined buyer (though they did, at least, cut their planned investment in WeWork from $16 billion to $2 billion).

The risk in betting against a stock like Softbank (or Tesla) is that sometimes visionaries are right, or admired enough to support the stock even if they aren’t right. I think there’s a high likelihood of disaster for Softbank shareholders and Vision Fund investors over the next few years, but “likelihood” is a lot different from “certainty.”

How about the actual financials? Their spun out Softbank Corp, which is the third-place Japanese telecom operator, went public in an IPO in Japan late last year and has remained persistently below the IPO price (it went public at 1,500 yen in late December, sold mostly to individual investors who are presumably looking for the dividend — it’s currently down about 10% from that level).

Book value depends on the valuations of the unicorns they’ve invested in, as well as on the US and Japanese telecom investments — so drivers in the near future could, to some degree, be the Uber IPO, as well as any developments at WeWork or their other major venture investments, but the overwhelmingly dominant holding of the company is Softbank’s 29% stake in Alibaba, worth close to $140 billion now before capital gains taxes (assuming, of course, that they could offload the stake without it dropping in value). That is more than Softbank itself is valued at, though that’s partly because of debt and partly because of taxes — if the stake were worth about $100 billion after tax, for example, then that would match up against Softbank’s current $100 billion market cap… and the worry for Softbank investors, then, is mostly just that they’re also carrying about $150 billion in net debt (for an enterprise value of $250 billion).

Alibaba is really what made Masayoshi Son a legend, his $20 million investment in that company almost 20 years ago, when it was a tiny startup, has reaped amazing returns that dwarf everything else Softbank has done… much like Naspers and its early investment in Tencent.

So if I were to get involved, how would I hedge a Softbank short? I don’t like to have short positions that are completely open-ended, mostly because of the risk that some surprise news could send the stock soaring by 30% overnight and cause a massive loss. I like to somehow temper that exposure so that I at least know my maximum risk.

Maybe call options on Alibaba would be a partial hedge, or call options on Sprint, covering its two largest optionable investments… that would make sure you’re protected from a surprise spike caused by the increase in value of those holdings, so the risk beyond that is that you end up with short exposure to Japanese telecom and to a portfolio of “unicorns” led by Uber and WeWork. That’s more or less what I like about this idea, but I am not yet convinced enough to actually make the bet, even with Softbank staging a quick rally recently that renews my temptation.

Grant’s Interest Rate Observer summed up the risks for Softbank in November:

“A short list of risks confronting SoftBank would include a potential failure in merging Sprint with T-Mobile; a slowdown in Chinese economic growth; a carve- up of Alibaba by the new Chinese tyrant for life, Xi Jinping; more intense competition in the Japanese telecom market; a realization on the part of investors everywhere that the unicorn is, in fact, a mythical beast and that profitability is the inherent attribute of business success.”

So Facebook is still in my portfolio, though much smaller in size than my position was a year ago… and I still have no exposure to Softbank, despite my persistent itch telling me to short the stock. I’ll let you know if that changes.

What else happened in the Real Money Portfolio this week?

I sent around a Trade Note yesterday morning, since I made another purchase in the Real Money Portfolio — here’s the text of that if you missed it:

Zayo Group (ZAYO) announced yesterday that the buyout talk wasn’t completely over after all, the word out on Wednesday was that they would postpone next week’s analyst day, with the implication being that they had at least one credible takeover offer that they had to consider (from Colony Capital, according to Bloomberg[6])… and then this morning Starboard, an activist “value” hedge fund that is one of the largest ZAYO shareholders, submitted a letter to the Board and CEO[7] advocating an open process for exploring “strategic alternatives.” It’s a worthwhile letter to read if you’ve considered or bought ZAYO, since they lay out what they think are some of the reasons why ZAYO trades at such a meaningful discount to the other infrastructure asset owners that are so popular (datacenters and towers, mostly).

My guess is that this provides a better near-term opportunity than I had previously expected to “unlock” that value, since interest rates are remaining low and leveraged buyout companies have so much capital available to them, though my primary reason for opening a position a month ago [8]was the likelihood that a 2-3 year REIT conversion process would also unlock substantial value (my $32 estimate being, I think, quite conservative and based on the assumption that ZAYO should be valued at least as richly as the worst comparison company, Uniti… though that specific comparative analysis is now out of date given that UNIT’s share price fell in half again on the bankruptcy filing of their major tenant, Windstream, and the delay in UNIT’s annual report filing as they work with their lenders to modify credit agreements).

My base assumption is still that the company, pending whatever strategic plan they outline at the analyst day (if it happens), should have a fair value in the low $30s, and that this value should be recognized within a couple years if we have to wait for the company to reorganize and restructure… but now we also have the renewed possibility that the company could be acquired at a meaningful premium or become more aggressive in its strategic review under Starboard pressure, and that potentially speeds up the clock a little (with the added possibility that if there is more than one possible buyer, we might see a buyout price of $35 or higher).

These are not ludicrous potential prices we’re talking about, but there should be some fairly easy money to be made because I think ZAYO is pretty cheap relative to the value of its assets and has been, Starboard believes, undermanaged as they’ve failed to get much efficiency out of their many acquisitions over the past few years. The shares were in the $30-35 range for a couple years before faltering late in 2018, and the near-term tantalizing notion is that the largesse of private equity might get us back there fairly soon… but I’m also willing to wait for 2021 and REIT conversion if this doesn’t end up working. I don’t think the buyout would be crazy high, we’re not likely to see the stock double or anything like that, so I wouldn’t want to chase it beyond the high $20s… but I think upping my position under $30 or so per share is worth the risk, with pretty limited downside risk of 25% or so, and I increased my holdings on the renewed Starboard pressure (and boosted my average cost up to just under $27 a share).

If they decide to back off from the potential acquirer(s) and go through with the analyst meeting and their 2-3 year REIT conversion strategy it would not be shocking to see the stock test $20 again as the short-term traders run for the exits (that would be the 25% downside potential), so I’m not going in with a huge position. This is about 1% of my individual equity portfolio now, and I’ll pop the popcorn and sit back and see what happens.

And that’s more than anyone should have to read for one week, so I’ll leave you there… have a wonderful weekend, and feel free to comment below if you’ve got any response to the above, any comments or questions, or even a bone to pick. Thanks for reading!

P.S. I did see Okta (OKTA)‘s earnings release (and slightly disappointing guidance) … I’m still thinking that one over, I have no changed my position so far.

Disclosure: I own shares of or call options on Okta, Nokia, Alphabet, Alibaba, Facebook, Fairfax India, iQiyi, Zayo, and Ericsson among the stocks mentioned above. I will not trade in any covered stock for at least three days after publication, per Stock Gumshoe’s trading rules.

Endnotes:
  1. “Weird New Antennas” pitch from Jeff Brown at Bonner & Partners last year: https://www.stockgumshoe.com/reviews/near-future-report-the/invisible-fiber-and-a-150000-windfall-by-july-27-whats-jeff-brown-at-bonner-talking-about/
  2. Jeff Brown’s pitched “$6 Digital King?: https://www.stockgumshoe.com/reviews/near-future-report-the/invisible-fiber-and-a-150000-windfall-by-july-27-whats-jeff-brown-at-bonner-talking-about/
  3. bearish article titled “The Netflix of China Might Just Be Wishful Thinking” in Barron’s: https://www.barrons.com/articles/a-chinese-neflix-might-just-be-wishful-thinking-51551480737
  4. presentation from the Promacta announcement is here: https://d1io3yog0oux5.cloudfront.net/_31fe0df976fa2beb555d1c057a477f46/ligand/db/242/1760/pdf/Petrus+Investor+Slides+vFINAL.PDF
  5. “privacy-focused vision,”: https://www.facebook.com/notes/mark-zuckerberg/a-privacy-focused-vision-for-social-networking/10156700570096634/
  6. according to Bloomberg: https://www.bloomberg.com/news/articles/2019-03-06/tom-barrack-backed-digital-colony-is-said-to-weigh-bid-for-zayo
  7. submitted a letter to the Board and CEO: http://www.starboardvalue.com/wp-content/uploads/Starboard_Value_LP_Letter_to_ZAYO_CEO_and_Board_03.07.2019.pdf
  8. opening a position a month ago : https://www.stockgumshoe.com/2019/02/friday-file-annual-review-completed-plus-a-new-special-situation/

Source URL: https://www.stockgumshoe.com/2019/03/friday-file-mysterious-m-boxes-and-more/


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