“Warren Buffett’s WORST NIGHTMARE Is About to Come True”

by Travis Johnson, Stock Gumshoe | May 9, 2014 4:15 pm

Sleuthifying a Fool pitch for the Friday File, plus some updates on companies I own and follow

May 12 Update: The lateset teaser pitch from the Fool is touting this same stock again, only with a different spiel from a different company as they tout the “connected car” instead of the “autonomous car”. I presume they’re just testing different ads to see what works best — this latest one pitches it as:

“You Use This $5.1 Trillion Industry Every Day…
“But It Just Died And Went To ‘Free Tech Paradise’….

“Your $48.8 Billion Windfall: Owning 1 Company Creating Today’s Connected Car Revolution.”

But it’s still the same company pitched as “Warren Buffett’s Worst Nightmare … back to our original article:

I’ve got a couple updates on some of the companies I own and write about frequently for you today — but first, the most-requested teaser pitch of the day is our headline topic.

The Motley Fool is pitching this “Buffett’s worst nightmare” stock in order to get subscribers to David and Tom Gardner’s Stock Advisor newsletter, and they open the ad this way:

“What happens when the perfect business model sustains a direct hit from the brightest minds at one of Silicon Valley’s most innovative firms?

“Tough to say exactly. But here’s what experts DO anticipate…

What’s that all about? The death of the auto insurance industry — which they tease is coming our way, sooner than you think, because of the advent of self-driving cars. Auto insurance is, of course, one of the major cash-gushing indexes owned by Berkshire Hathaway (BRK-B), primarily because they bought GEICO several decades ago and have poured as much money as they can find into marketing to grow that cash machine.

And no, not even the Motley Fool ad says that this will not be enough to seriously derail Berkshire specifically — but saying that something is Buffett’s “worst nightmare” does catch your attention and get you to read the ad, no?

Here’s some more in their words:

“An emerging technology from within the heart of Silicon Valley has the potential to destroy GEICO’s business as we know it.

“PricewaterhouseCoopers says this technology will ‘significantly disrupt the traditional auto insurance industry.’

“Renowned tech author Chunka Mui admitted in a speech to the Council on Foreign Relations: ‘The immediate losers are the people who depend on accidents for their businesses.’

“Even a former exec at Allstate acknowledges that, over the long term, ‘car insurance goes away.’

“Why? Because self-driving cars are moving from the realm of science fiction into reality.”

Self-driving cars are famously a big research project at Google, but Stock Advisor isn’t touting GOOG today — they’re teasing a company that builds the guts that can make a normal-looking, “real” self-driving car (without Google’s huge hardware package on the roof) a reality. Here’s more from the pitch:

“But here’s the kicker (and the real reason I’m writing you today)… as a gathering of tech leaders in San Jose, California at the end of March made certain (a meeting that received almost no media coverage!)… one shocking company stands at the forefront of taking this technology mainstream.

“This company is pursuing partnerships with the biggest names in the auto industry. It’s investing nearly one-third of its revenue into R&D to ensure its hardware is the hands-down favorite among automakers.

“And its CEO has been on a whirlwind tour both through the tech world (including addressing a ‘jam-packed’ room at January’s Consumer Electronics Show) and in closed-door meetings with auto execs — explaining why its hardware is capable TODAY of taking self-driving cars ‘from the realm of research into the mass market.'”

How about some more clues for us?

“You see, many stock pickers will try to pick the winning car manufacturer. Others will get sidetracked by fancy in-car technology like Apple’s CarPlay or GM’s built-in Wi-Fi.

“But the technology I’m sharing with you today has much greater potential….

“the tricky part about programming a self-driving car isn’t teaching a computer when to turn… or coding a camera to detect the speed limit.

It’s that — with all these inputs — these cars are ‘data guzzlers,’ as The Wall Street Journal recently put it. TRILLIONS of bytes of data are constantly pouring in, changing in real time, and requiring rapid responses.”

Then the really specific clues for our Thinkolator come in the description of this company’s recent presentation:

“The CEO of one of Silicon Valley’s most well-respected companies was giving the keynote address.

“You probably wouldn’t recognize him by name. After all, he’s not really the Steve Jobs — or even Tim Cook — type. He’s content running a behind-the-scenes hardware company that doesn’t usually make headlines.

“But as he was sharing his company’s latest advancements, he held the audience in the palm of his hands.

“After an hour and a half, the CEO throws a curveball…

“And introduces the head of product development from one of the world’s elite automakers.

“Together, they walk the audience through a video explaining what the two companies are working on — showing how sensors map out a virtual landscape that allows a car to determine where it should travel.

“Then the automaker VP says, ‘I brought something with me…’

“All eyes dart stage right as a sleek, silver sedan slowly drives toward them… and smoothly parks diagonally next to the two men.

“They go to open the driver-side door… no one is there!

“They walk around the side, coming to the trunk. Opening it up, they reveal the driver… by holding up the central CPU ‘manning’ the car (roughly the size of a notebook, it fits snugly off to one side.)

“The rep from the automaker then explains that the critical component powering the CPU is this tech company’s newest mobile processor.”

More on that key processor?

“The tech company’s CEO concedes that developing this processor was the ‘most ambitious project we’ve ever worked on.’ And that it’s ‘impossibly advanced.’

“A press release also explained that this processor provides ’10 times the computing power of previous mobile processors without consuming additional energy.’ And that it’s the same level of technology ‘that powers the world’s 10 most energy-efficient supercomputers.’

“Gary Vasilach, founding editor of Automotive Design & Production, one of the leading publications for automotive engineers, stood in awe, later writing that, ‘with four processors per car, a two-car garage would have as much computing power as the $120 million Blue Mountain supercomputer installed at the Los Alamos National Laboratory in 1998.’

“And that’s where many experts have this company incorrectly pegged — and why most investors haven’t caught on to this tech company’s true potential…

“Since the company has developed a ‘mobile processor,’ some analysts argue that the company is behind the times — that it doesn’t have a strong selling point with smartphone manufacturers.”

And this chip is already in use, apparently…

“Then consider that this company already has their products in more than 4.5 million cars (and growing!) — in everything from Porsches and Maseratis to Volkswagens and Hyundais… even Teslas!”

So who is it? Thinkolator sez that they’re teasing… Nvidia (NVDA), a $20 billion, dividend-paying semiconductor company that I don’t think I’ve ever taken a serious look at. They are priced at a premium to the market right now, in part because of some rapid earnings growth recently and because they’ve had nice upside surprises in their quarterly earnings three times in the past year, but analysts (other than the Gardner brothers, apparently) are pretty skeptical about growth — they’re penciling in just 7% earnings growth for the next five years.

The company has a great balance sheet, plenty of cash, a slowly growing dividend — and the Fool has been teasing it for about two weeks now that I’ve seen, during which the stock hasn’t moved much. But then they released earnings yesterday, and the stock is down about 3% as I type. You can see the conference call transcript[1] from last night here.

Their latest processor that’s being used in automotive and high-end mobile devices, the Tegra K1, is what’s being teased here. I know almost nothing about it, but there’s another story about that March presentation here[2] if you’re curious. They are gradually getting out of low-end graphics chips that carry lower margins, it appears, and aiming for the data-intensive operations — of which automotive is just one. They’ve been aiming to get their sales to the automotive segment up to a billion dollars, which would be about a quarter of their total revenue from the last year, so it should be substantial but it won’t be the single “driver” of the stock.

When will the autonomous, “self-driving” cars become a reality? Some folks are predicting that they’ll be common on the road within five years, but it’s awfully hard to predict adoption – and even if cars aren’t really “self-driving” in this decade, they are becoming smarter and smarter and requiring more and more data processing capacity, we’re told. The Foolies say that…

“The big money is made somewhere between widespread popular disbelief and when the technology is found in every home .

“Like with Microsoft in ’86… before the home PC revolution took off (and handed early investors a 56,000%+ gain).

“Then with AOL in ’94… before everyone and their grandma were using those shiny ‘free Internet’ CDs (handing early investors a 20,000%+ gain).”

So… interesting stock, you can’t really call it a cheap stock at this point, and they’re in an extremely competitive market, but it looks like David Gardner is thinking outside the box a bit and envisioning a much faster ramp-up of automotive processing power, and that NVDA will lead that charge. Seems possible but is certainly not guaranteed — it’s a growth stock, with a growth valuation, in a market where they’re mostly competing against large companies that are cheaper (like Intel and Qualcomm). I’m not running out to buy the stock, particularly since I really have never looked at them before today, but it’s an interesting story. If you’d like a negative spin on NVDA for balance, there’s an interesting analysis (heavily debated) at SeekingAlpha here[3] from the time of their last earnings release. Yesterday’s earnings also got mistakenly leaked earlier in the week, and a Fool writer wrote that they “looked great”[4] at the time.

I have a few other notes for you today, too — mostly on earnings, with some small moves in my portfolio as a result:

Rosetta Stone (RST) — they’re continuing to invest, but they’re not getting nearly as much traction as I was hoping for. The company has been systematically investing its cash hoard into expanding their brand reach, including buying the “brain training” brand Fit Brains, but sales of the core Rosetta Stone product are weak enough that I’m concerned. Investors were not happy with RST’s earnings report this week, and the stock dropped about 10%. The argument for RST continues to be that they are transitioning to online subscriptions and downloads of their software (away from the kiosks and boxed software sales that built up their “yellow box” brand recognition), but that this transition comes at a price because they’re backing away from weak sales markets in Asia and also losing those lucrative CD sales that boosted revenue (the price for those was too high, including the large marketing cost, so it wasn’t sustainable — but it did generate much higher revenue). They’re also leveraging both their brand name and their online and institutional sales capabilities to sell children’s learning products, including the Lexia reading products to schools that have been growing sales nicely, and now the Fit Brain products that are number two in the adult “brain training” segment behind the heavily marketed Lumosity.

Small-cap Value investors have been recommending this stock for a couple years now, I initially featured it as an Idea of the Month after David Nierenberg presented it at the Value Investing Congress about a year ago, and it was also presented by a different hedge fund guy at the Congress a few weeks ago. I have been hemming and hawing over RST for months now, and I finally decided to let the market make my choice for me on this one, letting it go on a stop loss right around $10.

And my two reinsurance companies, Greenlight (GLRE) and Third Point (TPRE), both reported recently — with no huge news.

Greenlight just barely made an underwriting profit (meaning, their premiums earned minus costs and claims paid was positive… slightly). Underwriting performance is commonly reported using the “combined ratio”, with anything under 100 meaning the insurance side of the business is profitable; and anything over 100 meaning the insurance side is losing money and being subsidized by the investment portfolio. GLRE did not have a great quarter, their combined ratio was 99.9, and they lost a little bit of money on their investment portfolio run by Chairman David Einhorn (investment loss was less than 1%) — which basically means that they broke even on that quarter, the book value dropped by about 40 cents to $27.61. Underwriting performance was slightly better than the year-ago quarter, but investment performance was substantially worse. Einhorn said the first quarter’s weak investment result was caused mostly by their macro bets (like gold, presumably) and their short positions, the long portfolio did well. April was also a good month for Greenlight’s portfolio, he said the investment portfolio was up better than 4% in April, in part thanks to a large Apple position (they report investment performance monthly here[5]).

Greenlight’s CEO, Bart Hedges, reiterated what a lot of insurance people are saying — that there’s too much money in the reinsurance market (because of these hedge fund guys and nontraditional insurers getting into the market, including newer entrants like TPRE), so the prices are too low and they’re not aggressively growing:

“We continue to look for profitable areas of the market to deploy our capacity but the market is competitive in nearly all sectors and new business opportunities are challenging to find.”

The insurance business is not going to grow by leaps and bounds, but my base assumption is that it can break even or make a couple percent in earnings in most years and supply David Einhorn with free leverage for his investment portfolio, and I expect that portfolio to be able to perform very well over the long term — as it has. This is primarily a way to invest with David Einhorn at lower cost, including his short positions that should protect some against a very weak market whenever that comes, and I think it’s still a very reasonable buy up to 1.2X book value — that would be about $33. It gets more compelling down at 1.1X book ($30.37), but this has become a substantial position for me and I may nibble more. The stock is not very closely followed by many, and it’s not that complicated — there weren’t even any questions from analysts on the conference call. I kind of like that.

Third Point had a better quarter than GLRE, they continued to have underwriting losses (combined ratio of 107, similar to last quarter but an improvement over a year ago) but still made money thanks to a strong investment performance, up more than 3% in the quarter. Their April wasn’t as good, for whatever that’s worth (investments down 1.4%, they report investments monthly here[6]), but Jan-Mar were solid. That brought diluted book value up to $13.43, and the stock came down a bit after the report to trade in the low $15s. I still think that this is a good buy up to $16, though that does depend on the underwriting continuing to improve and on that combined ratio getting close to 100 over the next year — we can’t count on Loeb to beat the hurdle of a 7-10% underwriting cost forever, though it has gone well so far. The hidden value of these companies is that the investment portfolio can compound itself and keep growing — right now, the net investment portfolio managed by Loeb’s Third Point is $1.6 billion, which is $15.75 per share, so earnings on that $15.75 have a somewhat levered impact on the $13.43 per share of book value (sort of like paying someone a dollar to get the earnings on $1.15 of investments — there are costs involved too, of course, including the hedge fund fees paid out of that investment portfolio, but this kind of leverage on money they don’t “own” but can invest is what allows insurance companies to grow and compound book value).

Both TPRE and GLRE are essentially ways to invest with hedge funds at low cost — with the hope that their insurance operations will provide a bit of a kicker (free leverage) when they operate well, and will not have too many mistakes that cost them a lot. GLRE has had a few very bad underwriting quarters but has, I think, learned from that, and TPRE, while new and not yet up to profitable scale, is run by an excellent insurance team with long experience. I know I’m not nearly as good an investor as Dan Loeb or David Einhorn, and I like having them effectively running some of my portfolio through these operations. Particularly when it doesn’t cost much and we don’t have to pay a big premium over book value. I bought a few more shares of TPRE today.

Finally, I should let you know that I also opened a small position in SodaStream (SODA) today — I featured that as my Idea of the Month after the last Value Investing Congress, thinking it looked appealing near $40, and then it shot up on rumors of a Starbucks investment in the company. The rumor faded, the company is still the same, and the stock came back down to a better price, I bought my (tiny) opening position at $41 and change, I’m hoping that the first quarter report will show an inventory overhang and weak earnings but positive signs for future growth and stability… and that it will bring the price down so I can buy a larger position, we’ll see — they are expected to release their earnings on Wednesday.

Have a great weekend, everyone!

Endnotes:
  1. see the conference call transcript: http://seekingalpha.com/article/2205803-nvidias-nvda-ceo-jen-hsun-huang-on-q1-2015-results-earnings-call-transcript
  2. another story about that March presentation here: http://www.slashgear.com/audi-self-driving-car-brings-nvidia-tegra-k1-front-and-center-25322090/
  3. interesting analysis (heavily debated) at SeekingAlpha here: http://seekingalpha.com/article/2018521-nvidias-tegra-business-collapses
  4. Fool writer wrote that they “looked great”: http://www.fool.com/investing/general/2014/05/08/nvidias-preliminary-results-look-great.aspx
  5. report investment performance monthly here: http://www.greenlightre.ky/FinancialInformation/InvestmentReturns.aspx
  6. report investments monthly here: http://www.thirdpointre.bm/investors/financial-information/Investment-Portfolio-Returns/default.aspx

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