Daktronics-DAKT

My History With DAKT

Daktronics is one of the first public companies that I really started paying attention to. It is one of the largest and probably the most well known public company in South Dakota. I went to college for my first two years in Brookings at South Dakota State University, where Daktronics is based. That is where I met one of my heroes in life, John Sondey. John was an economics teacher whose true passion was investments. Fortunately, as a Freshman in college I met him and he noticed my interest in the stock market. Then he allowed me to take his investing class that was normally reserved for seniors. This was really the beginning of my formal education in investing. During the class he let us invest $12,000 of his own money in 6 different stocks. At the end of the semester if we made money, we gave half of the proceeds to the local food shelf. The other half of the proceeds were distributed to the students in the class! After the last class of the semester that money was promptly reinvested in the local downtown establishments.

Since Daktronics was based in the same town, and had so many connections to the University, it was often a topic of conversation in class.

Company History

Drs. Aelred Kurtenbach and Duane Sander founded Daktronics in 1968 while they were professors of electrical engineering at South Dakota State University. The company has always maintained a close relationship with the University which has been able to provide it with highly trained engineering talent and other full and part-time employees.

The companies first product was a voting system display that was sold to the Utah Legislature in 1970. In 1971 it expanded the business into scoreboards and in 1973 into commercial displays. The company continued to innovate and in the 1980's successfully sold scoreboards for the 1980 Olympic Winter Games, college athletic facilities, and its first major league facility. In the 1990's the company successfully implemented LED technology into it's video boards and expanded into further product lines. In 2002 the company had its initial public offering and was the world market share leader in LED video displays with over 26.5%. Their market share has since grown to 29%(1). The New York Times had a great feature on the company in 2014.

The company has a large percentage of insider ownership and it seems that it is mostly controlled by the founder Aelred Kurtenbach and insiders. Reece Kurtenbach, Aelred's son, is the current Chairman of the Board and CEO of the company. Jim Morgan, the CEO from 2001-2013, owns a sizable stake in the company and is on the board of Directors.

Ownership % Shares Value Dr. Aelred Kurtenbach 5.2% 2,277,392  $   20,769,815 Reece Kurtenbach 1.0% 417,223  $     3,805,074 Jim Morgan 3.4% 1,490,456  $   13,592,959 DAKT 401k Plan 5.7% 2,495,664  $   22,760,456 15.3% Shares Out    43,762,596 Share Price  $           9.12

Business and Segments

Daktronics reports its' figures in 5 different business segments: Commercial, Live Events, High School Park and Recreation, Transportation, and International. Below is a brief analysis of each.

Commercial

You might find these display systems at gas stations, restaurants, casinos, amusement parks, or even in Times Square and the Las Vegas Strip. These displays are typically used to inform customers of events or prices. This business represents about 27% of Sales for Daktronics. It's Gross Margin is also 27%. This part of the business has been seeing larger and more customized displays being built in recent years. I suspect it is likely that this trend continues in the future as displays get better and more dynamic. This business has produced consistent profits overtime, with the only anomaly being in 2009.

Live Events

These are the largest and most dynamic of Daktronics video display systems. You will see these in most of the large stadiums in the United States. Some examples include Sports Authority Field at Mile High (Denver Broncos), Levi's Stadium (San Francisco 49ers), and Target Field (Minnesota Twins). New stadiums are building larger video boards than ever and it seems that this trend will only continue. The expected lifetime of this equipment is 8-12 years so once installed their is a natural replacement cycle provided Daktronics can win the job again.

Not only are they building large video boards for replays, but stadiums are adding many smaller banner type boards for advertising and other purposes. For example, the group that owns the Denver Broncos stadium expects a 2 to 3 year payback from advertising revenue on the banner displays they recently installed in their stadium. With such strong returns it is not wonder that other stadiums have been purchasing these boards as another source of revenue. 

This business sometimes has lumpier sales just because of the timing of large stadium projects. It currently represents 38% of Sales for Daktronics. It does have lower Gross Margins than the Commercial business though, coming in at 18% in 2015.

High School Parks and Recreation

Daktronics is one of the leaders in providing scoreboards for high school athletic and theater activities. This was one of the first businesses that the company entered and has had rather stable sales overtime. Like in the other segments, schools are seeing value in higher end scoreboards for advertising. They are also being adopted as message centers for students, faculty, and community members. This segment represented 11% of Sales and maintained healthy 32% Gross Margins in 2015.

Transportation

The Transportation business builds signs for roadways, airports, parking structures, and various other applications. I see their signs all of the time on my way to and from the Minneapolis-St. Paul Airport. Historically this has been one of the higher margin businesses for Daktronics. Their Gross Margins have generally been around 30%. This is the smallest business unit though with just $48 Million or 8% of company Sales. I believe the company has a good future in the business as the world adopts more intelligent transportation systems and improved communication systems for travelers. Unfortunately, this segment has more competitors than some of the others so it's growth might be mitigated.

International

The company includes all business sales internationally in one unit so it is hard to get true clarity on the mix of products. The company says that commercial video systems, digital billboards, and transportation systems are their main products. The large US style Live Events scoreboards have not caught on in the rest of the world yet. Particularly with Soccer stadiums in Europe and South America. FIFA seems to be concerned about crowds becoming agitated over replays, and not having undue influence on the referees. I suspect this will change as stadiums try to improve the fan experience. I know in the US the use of the large billboards is much appreciated by the fans, but time will tell. The company has been growing very nicely internationally, increasing Sales from $51 Million in 2008 to $102 Million in 2015. 

Competitive Advantage

I believe that Daktronics has a pretty good competitive advantage. It is certainly not a great one like Visa has but it isn't a terrible one like Airlines historically have been. I would say it is somewhere just above average. The market had about $2.1 Billion in Sales in 2014 and Daktronics has a 29% market share with the closest competitor having just 9% of the market. They operate in a very niche industry that requires rather specific engineering expertise and I think this would be difficult to replicate in a short amount of time. Also, the margins are pretty good but not super high. Thus, I don't see a good reason for another company to pour hundreds of millions of dollars in plant and equipment to try and compete. 

Valuation

And now the most important piece of the puzzle. Over the last 10 years Daktronics has experienced rather lumpy financial results. Despite this, Sales have grown from $230 Million to $615 Million or 10.3% compounded. Owner Earnings Per Share meanwhile have not grown at quite that rate, only about 6% compounded.

Cumulatively, over the last 10 years I estimate that Daktronics made $6.10 and paid $3.05 of that out in a dividend. In 2015 I think Owner Earnings Per Share were around 63 cents (different from the the graph) as their were some abnormal working capital changes.

In the last 5 years the company has decided to pay most of their free cash out in a dividend. While this is not necessarily a bad thing, I tend to prefer a company that can reinvest in its own business. Daktronics has built new plants and added production lines in recent years, but has had the fortunate "problem" of having extra cash around.

I am glad that the company has not repurchased stock. Because, for the most part over the last 10 years the stock was not significantly undervalued. I do question whether they could have made an acquisition that would have helped the company. Maybe a supplier or one of their competitors. I cannot criticize this point to hard though as I do not have a good idea of what that acquisition might be.

In the future I expect Daktronics to continue to grow Owner Earnings Per Share at about 5-8% rate compounded, though this will be lumpy. I also expect the company to continue to pay out most of it's excess cash in a dividend as that seems to be the desire of the founders and management that are on the board of directors.

I believe Daktronics Intrinsic Value is around $7 per share so I would like to purchase it at a good discount to that. Currently shares trade at $8.86. Not excessively higher than my estimate of Intrinsic Value but not at a price that I find interesting. If the stock prices comes down a ways below $7 there is a good chance I would be purchasing shares in Daktronics.

Happy Holidays!

1. Daktronics Q2 2015 Investor Presentation Page 5
2. 10 Year Daktronics Financial Results 

Powder River Basin: Part 2

The Powder River Basin has been one of the most important energy assets for the United States over the last 45 years. But now its future importance appears to be declining. In 2011 coal production peaked at 426.4 million tons but by 2014 had decreased to 381.2 million tons. I believe that further declines in production seem likely as more utility companies are producing energy from natural gas, wind, and solar power. In this second piece I am going to speak briefly to the valuations of some companies that have significant operations in the Powder River Basin. Unsurprisingly, they have all been negatively affected by the declines in coal prices and production.

Black Hills Corporation (WyoDak Mine, BKH)

The WyoDak mine is the longest continuously operated surface mine in the United States. The mine was started by the Homestake Mine Company of Lead, South Dakota and was sold to the Black Hills Corp in 1956. WyoDak is very unique in that it uses a conveyor belt to move the coal out of the mine. As opposed to coal haul trucks like in the rest of the Powder River Basin. The WyoDak mine is also unusual in the fact that not all of the coal is loaded onto trains. Rather it is fed directly to the 335 MW WyoDak Power Plant, which is 20% owned by Black Hills Corp. The other 80% owner of the plant is PacifiCorp, a Berkshire Hathaway Energy subsidiary.

Black Hills Corp owns 16 power plants that generate 841.1 MW in Colorado, Wyoming, and South Dakota. The WyoDak mine represents about 9% of the overall company’s energy production. Utilities are unique businesses in that their rates are regulated by the various utilities commissions of the states they operate in. Because energy use has increased in the past these utilities must expand their operations (capital expenditures). Generally, the state utility commissions allow the utilities to earn about a 10% rate of return on these new investments. Thus, utilities earnings are normally very consistent and easier to predict than some other industries.

In 2014, Black Hills Corp had net income of $129 million or $2.90 per share (in this case net income is a good proxy for earnings). Currently, the stock price is $46.02 for a market cap of $2.06 Billion. Thinking about this as a private investor, I would be accepting an initial return of 6.3%, for a business that will likely grow its earnings by 10% per year in the future. This is not cheap enough to be interesting for me. Now 4 years ago when it was selling for $29, it would have been.

I am not a merger and acquisitions expert but Charlie Munger had an interesting quote at the Daily Journal Meeting in Los Angeles last year.  

“Berkshire will have the biggest utility business in the U.S. in a few years. It will be OK to make 9-10% returns, with 0% float money with interest rates at 0. They (shareholders) will live that it isn’t 12%.”

Given that PacifiCorp already has a business relationship with Black Hills Corp. and Berkshire wants to acquire utilities it would not surprise me to see Black Hills Corp be acquired by Berkshire at some point in the future, albeit probably at a lower stock price.

Cloud Peak Energy (CLD)

Cloud Peak Energy is the only publicly traded, pure play, Powder River Basin mining company. The company was originally part of mining giant Rio Tinto but was spun-off in 2010. In 2014 Cloud Peak operated 3 mines in PRB and sold 87.1 million tons of coal, which accounts for 23% of the production in the basin. The decrease in coal tons sold and coal price has hurt earnings significantly. In 2012 the company had $173 million in net income yet this has decreased to $78 million in 2014. 2015 is looking even worse. The stock price has followed suit decreasing from $20 to $4 (-80%), for a market cap of $240 million.

Predicting the future earnings of Cloud Peak is rather difficult. With coal usage likely in a secular decline the company may continue to struggle in the future. The company looks cheap when looking at past earnings, but for now I have to put this in one in the “too hard basket”.

Union Pacific (UP)

The Union Pacific is one of the two largest Class I railroads in the United States. With the lowest operating ratio, 63.5%, UP is arguably the best managed railroad in the industry. The company derived 18% of its revenues from the coal business in 2014. Coal from the Southern Powder River Basin, including Cloud Peak Energy coal, makes up the majority of this business. In 2015 Burlington Northern Santa Fe, UP’s biggest competitor, had some big issues delivering its customer’s goods on time and lost market share to Union Pacific.

In 2014 I estimate that UP had owner earnings of $4.7 billion or $5.23 per share. With the current stock price of $95.85 we would be accepting an initial return of 5.4%. UP does not interest me at this stock price. Especially when you take into account that the business is operating at a world class level, at some point all businesses make mistakes or run into problems. The coal business also generates some concern because if there is a secular decline then those revenues will have to be made up elsewhere. This year coal carloads are down 7% but revenues are only off 5% because of increased prices. Now, I don’t think Union Pacific will have major problems with its business overall. But, they may struggle to grow the business at an exceptionally high rate like in the past.

Rail Link (Genesee & Wyoming, GWR)

One would think the Union Pacific and Burlington Northern train engineers would just drive their trains right to the coal mines to load the coal, but that is not the case. As I mentioned in the previous post, the engineers stop their trains and hand off the driving responsibilities to the employees of Rail Link. The Rail Link engineers then communicate with the coal loading facility and set the train at the appropriate speed, between .5 and .7 mph, for loading. The coal is then loaded onto the continuously moving train. This process usually takes between one and two hours. Once the coal is loaded, the engineer drives the train to the appropriate spot and hands off the train to the Class I railroad engineers.

The Rail Link coal loading business is only a small part of its parent company, Genesee & Wyoming. For the G&W the non-freight business represents 24% of revenues, which is also split between the company's industrial switching and port operations. The exact numbers for each division are not disclosed. The other 76% of revenues come from the short-line railroad freight business that G&W is known for.

In the last 15 years the G&W has purchased 98 short-line railroads. These are mostly located in the US but they also have operations in Australia and as of very recently Europe. As one might guess, the company has seen spectacular growth in Earnings Per Share. When the company IPO’d in 1996 they had EPS of $.29 and by 2014 EPS had grown to $4.58 for a compounded annual growth rate of 15.6%. This is one of the fastest growing businesses I have seen over a long period of time and obviously the managers have done a great job of managing all of the new acquisitions.

 In 2015 the company has seen revenue and earnings growth take a pause, because their freight coal and coke carloads have declined 34.4% year over year. But they did just acquire Freightliner, a European rail company, which should increase earnings for the year. Once that acquisition is completed I believe that GWR will have normalized owner earnings in the $6.10-$6.60 per share range. Currently the stock price is $75, for an initial return of between 8.1-8.8%. For a fast growing company this is starting to look interesting.

There is an important caveat though. The company’s debt is in term loans which adjust with interest rates and are mostly due 3-5 years from now. If interest rates go higher this could slow growth from the very high rates we have seen in the past. Also, the short term nature of the debt could potentially cause problems if credit is not easy to obtain. Because of this risk I must wait for a lower stock price than what it currently is at. I will admit it is getting close though.

Burlington Northern (Berkshire Hathaway, BRKA, BRKB)

As you can see from the map the BNSF and the Union Pacific have a very similar geographical footprint, mostly the western United States. Not surprisingly, they are very similar companies in size, measured by revenues and net income. The BNSF has a slightly higher mix of coal car loads (+4%) and intermodal car loads (+2%) than UP. While UP moves more chemicals and industrial products (+4%). 

Despite being tough competitors both companies have increased EPS by large amounts over the years. In just the last 4 years, UP increased earnings by 20.1% compounded annually and 108% in total. BNSF increased earnings by 13.3% compounded annually and 65% total during that time. BNSF likely would have been able to boost the EPS numbers more by repurchasing shares, but in 2010 it was purchased by Berkshire Hathaway.

The BNSF contributes 11.7% of revenues and 22.1% of net income for Berkshire and will be a very important asset for years to come. Because of the many operations of Berkshire Hathaway I will wait for another post to analyze the company in its entirety, stay tuned!

The Powder River Basin and Fly Fishing: Part 1

Sometimes you just have to get out of the office and get away from things so you can think clearly. While some investors are very successful simply working out of their office I find that I do some of my best thinking when I am out of my element or visiting a place and experiencing something new.

While I was growing up I was fortunate enough to take a summer vacation with my parents out West every year. Wyoming was always one of our favorite places to visit because of the breathtaking scenery and the outdoor activities. We enjoyed it enough that we nearly moved there once! As you enter Wyoming on Interstate 90 from the East you drive past miles of trains and large coal mines. I was a little obsessed with trains as child and I was also amazed by the size of the mines! I’ve always thought it is pretty crazy to think that we can completely change the landscape of earth.

For the last couple of years I have wanted to go back and take a tour of the coal mines. Yes there are a lot of Youtube videos out there, but there really is something to be said for actually SEEING the sheer size of the operations up close. In addition, there are a number of companies that I have researched that have significant operations in the area including Cloud Peak Energy, Burlington Northern Santa Fe (Berkshire Hathaway), Union Pacific, Rail Link (Genesee & Wyoming, a short-line railroad company), and Black Hills Energy (largest company in South Dakota).

I am going to break this blog into 2 parts because there is a lot of content. I guess I learned a lot last week! The first part is about the Powder River Basin, and its significance for the United States. I will also talk briefly about my fishing adventures while I was traveling. Part 2 of the blog, which will be released soon, will give a brief analysis of some of the companies that operate in the Powder River Basin. 

The Powder River Basin 

Coal is the largest source of electricity for the United States, representing about 39% of total electricity production. The Powder River Basin (PRB) produces 40% of the coal used in the United States. In short, between 10-15% of US energy production comes directly from the PRB. In the early 1970’s the Energy Information Administration began to realize the environmental effects of high sulfur coal, notably acid rain, which has traditionally been mined in the eastern half of the United States. The EIA then started a push for mining in the Powder River Basin. While relatively low in energy content compared to eastern coal, the coal that is produced in the PRB is very low in sulfur content.

The Belle Ayr Mine started production in 1972 and was the start of PRB mining era. In 1972, Wyoming produced about 10 Million tons of coal. Just 10 years later this had grown to 140 Million tons. By 2011 production in the Powder River Basin peaked at 426.4 million tons! Since then production has been decreasing. In 2014, 381.2 million tons of coal were produced in the basin.

Mining

Most of the coal seam in the PRB is 100 feet underground. In order to get the coal out of the ground, the land (overburden) must be dug up and moved. Draglines (large excavators) shovel the earth in their buckets and place it into massive dump trucks. These Draglines are among the largest pieces of machinery in the world and cost upwards of $100 Million each!

I am standing in an old 24 ton bucket. Some of the new buckets, like the one white ones shown below can move 80+ tons of material! 

Once the overburden is removed and the coal can now be excavated. Oftentimes the coal and land must be broken up to make excavation easier. This is accomplished with the use of explosives, mostly ammonium nitrate because of safety in transportation and its cost advantage over explosives like dynamite. Explosives teams drill holes and set the charges into the coal seam. The charges are then detonated and the Draglines go to work loading the coal into the coal trucks and overburden into other haul trucks. These trucks are true modern marvels. The Alpha Mine, where I did my tour, uses mostly 793 Caterpillar trucks that cost about $4.3 Million, hold 1,200 gallons diesel, and can carry 253 tons of material!

Next the coal trucks drive the coal to the loading area where it is dumped. At the Alpha Mine this was about 2 miles away. Once the coal is dumped it is then tested for its heating and sulfur content, and various other quality issues. Some Utility customers want different characteristics in their coal so the mine employees test and determine the characteristics of each batch of coal. Next they must prepare and organize coal with the correct quality characteristics to load onto the trains for the customers. Trains are loading coal 24 hours a day so this must be a relatively complicated task. Once the batch of coal is prepared it is sent on huge conveyor belts into silo's where it will be loaded onto the trains.

Above is a picture of a truck preparing to dump and the loading facility in the background.

Transportation

Coal is moved around the country by two main Class I railroads, the Burlington Northern Santa Fe and the Union Pacific Railroad. These railroads drive their 110-120 car unit trains into the PRB, but not all the way to the mine's loading facility. As the trains get close to the loading facilities the Class I engineers exit the train and hand off the driving duties to employees from Rail Link, owned by Genesee & Wyoming, a short-line railroad operator. The Rail Link engineers then communicate with the mine's loading facility to set the correct speed for loading the train, between .5 and .7 mph. The coal is then loaded into the rail cars as the train continues to move.

 

A BNSF Locomotive and coal being loaded into the train cars.

After the coal is loaded it is then sprayed with a dust suppression agent. Once the train exits the loading facility Rail Link hands the train back to the Class I carrier and it heads off to the Utility customer. It takes between one and two hours to load a whole unit train but between seven and eight to unload. Weird right? This is because each rail car must be turned upside down and emptied! Once the train is emptied it leaves the power plant and starts its trip back to the Powder River Basin.

Fly Fishing

The other part of my trip was to enjoy one of my favorite pastimes, which I have not made time for in the last few years. When I was young I was fortunate to have an uncle who was an expert fisherman. Fortunately I picked up a little bit of his wisdom and joy for fishing. 

It was extremely nice to be disconnected from the internet and my cell phone and just enjoy nature. Even if it was just for 24 hours. I find that I do some of my best thinking when I just get to relax and not be distracted. And this time must have been productive because I came home with a lot of new items on my to-do list!

The water was very high and there was flooding in much of the Black Hills. So I knew my stream selection would be limited to the uppermost portions of the streams. Fortunately, the people at Dakota Angler & Outfitter Fly Fishing in Rapid City helped me pick out some good Nymph's and sections of some streams to go to. 

Sometimes the fishing crowd can rather secretive about their tactics, but I have always found the exact opposite with the Fly Fishing crowd. In this case I fished next to a fellow angler who fishes the area rather often. I wasn't catching much right away, so he insisted that I come up next to him (I'd seen him catch at least 8 fish in 45 minutes). And of course I started catching fish right away. Funny enough he worked for the Burlington Northern Santa Fe, so I peppered him with questions all day. I had a wonderful time fishing with him and exchanging stories. It really was perfect quick getaway. 

    

The trout that I caught and some of the scenery in the area.

And here is a video of me catching and releasing a Rainbow Trout.

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The Berkshire Meeting: My Favorite Weekend of the Year

As I sit here reflecting on the past weekend I can’t help but realize how it is by far my favorite weekend of the year. The Berkshire Hathaway Annual Shareholder Meeting brings together such an extraordinary group of people from all around the world. Just this year I saw or talked to Muhtar Kent (CEO of Coke), Larry Van Tuyl (new Berkshire Auto Dealer subsidiary), Carl Ice (CEO of Burlington Northern), Becky Quick, Jean Marie-Eveillard, Bill Gates, and plenty of super talented investors. OK these might not exactly be household names but they are big in the investment and business world. And this is in Omaha, Nebraska no less!

I have found that most investors are kind of lone wolves. We sit in our homes and offices, read voraciously, and think about the world and the businesses we invest in.

Myself with my new international investor friends Anders Heegaard (London) and Peter Sorensen (Copenhagen)

Quite a few of us exchange emails or post on message boards but oftentimes there is not a lot of face to face interaction with our peers. Except for the Berkshire weekend, where we get to meet the faces behind the forum name! This is one of the few places where we can actually talk shop. I’m sure plenty of the people in my social group get bored of me talking about my stocks. But here there are people whose favorite topic of conversation is stocks! 

For example, on Sunday after the Markel meeting I hung out with a couple of investor buddies just talking about what our favorite businesses were, bad investments we’ve made, and hypothetical scenarios. Like could Berkshire and 3G Capital buy Coca-Cola, and then trying to design a deal that worked (it is close by the way). While we were doing this Andrew Ross Sorkin walked by, unfortunately he had to work so we couldn’t pitch him our idea, which I think would make for an interesting Dealbook article. 

The whole weekend is just go-go-go but it is so intellectually stimulating that it doesn’t even matter. Until Sunday night when my body crashes from the lack of sleep, I guess staying up for 22 hours on Saturday will do that.

The Meeting

I always enjoy showing people around Omaha for the first time because I remember the first time I went to the Berkshire Meeting so many years ago. It was such a moving and eye opening experience that I vowed to never miss one again (so far I have been successful).

Myself and my friend Jeremy Saltzberg who was attending the Berkshire Meeting for the first time

Normally, I am content to just get a seat in the Century Link Center and do not get in line terribly early. But this year I decided to get in line a little extra early, at 4:15 am, to get a good spot on the floor and chat with other diehards. For those that have not attended the meeting it starts with a 30 minute movie. Of course Warren Buffett & Charlie Munger are the stars, along with the Berkshire managers, and GEICO’s various mascots (Hump Day Camel and the Gecko). It is rather corny but always good for a laugh. This year the movie featured Ellen DeGeneres, Little Richard, Arnold Schwarzenegger, Jamie Lee Curtis, and was directed by John Landis the director of Animal House and Blues Brothers. The highlight for me was when Buffett challenged Floyd Mayweather to a boxing match. I was impressed by Warren’s trash talking, which unfortunately had to be mostly bleeped out because of profanity. I find an old man swearing to be way too funny!

Following the movie we enter 6 hours of Q&A with a 1 hour break for lunch in the middle. This is what I come for.

Warren Buffett and Charlie Munger

Many of the same questions are asked each year and they normally get similar answers. Warren usually gives long winded answers to good questions and Charlie generally does not add much. His catch phrase is “I have nothing to add”. But when he does add something it is nearly always very blunt, and rather hilarious. And sometimes he will give a long-winded answer, at which you normally realize that was one of the most intelligent things you have ever heard. They banter back and forth quite well and make one heck of a team.

This year there were some great questions about Berkshire’s partnerships with 3G Capital and their acquisitions of Heinz-Kraft. 3G has a history of cutting costs out of businesses, especially in businesses that are not well run. Some people were rather bothered that sometimes the cost cuts involve cutting jobs (normally at corporate headquarters). Buffett responded by saying that no Berkshire company has a policy of employing more people than it needs. And Munger thought if companies allowed themselves to over hire they were moving towards a socialist or communist country. So he chipped in with a quote about the communist USSR: “They pretend to pay us and we pretend to work.”

After a question about Berkshire’s investment in IBM Charlie also chipped in one of his funniest quotes of the day:

“Warren, if people weren’t so often wrong, we wouldn’t be so rich.”

In another exchange Buffett talked about his biggest mistakes being missed opportunities. But he’s never willing to take risks that might endanger the net worth of his partners, the shareholders. They could use more leverage, to which Charlie responded:

“But we would have been sweating at night. It’s crazy to sweat at night.”

Buffett: “Over financial things.”

Munger: “Over financial things.”

Buffett: “Well, we won’t pursue that.”

Another favorite of mine was a question about whether France should abandon the Euro and revert back to the Franc as a currency, and whether the Euro was a good idea or not. To which Charlie gave his best quote of the day:

“I don’t have the faintest idea . . . It’s a flawed system in some ways to put countries that are so different together. You can’t form a business partnership with your frivolous, drunken brother-in-law.”

Buffett: “Everything here is off the record.”

As you can tell Warren and Charlie add a very nice dose of humor to the meeting. During the meeting I couldn’t help but think to myself how much both of them enjoy sharing their wisdom and thoughts on the world. They might not have the titles but they are both teachers.

At the shareholder meeting there is also a convention hall with booths from the various Berkshire companies. Naturally, you can purchase their products such as Dilly Bars from DQ, cowboy boots from Justin, car insurance from GEICO, Fruit of the Loom underwear, books from Bookworm, See’s Candy, and numerous other things. They keep detailed records of how many items are sold at the meeting, and like the meeting itself, the records grow each year.

Wells Fargo Stagecoach, a Berkshire holding, in the convention center that was built in Letcher, SD (REPRESENT!) 
http://www.wsj.com/articles/horse-drawn-carriages-fetch-luxury-car-prices-1430345003

Family

For me, the weekend holds a special place in my heart because it is not all about investing. I always stay a few extra days because a lot of my extended family lives in Omaha. My Grandmother grew up in Omaha and as a child I always loved to hear her stories about growing up. I’ve always enjoyed listening to people’s life stories and when I first read Snowball, a biography on Buffett, I couldn’t help but be reminded of many similarities in her childhood and Buffett’s (they were born just a year apart).

The house my Grandmother grew up in on 44^th and William St.

While most of the weekend is dedicated to investing events I always make time to see as many of my family members as I can. My Great Aunt and Uncle Pat and Peg are always gracious hosts and I really treasure all of my late night conversations with them (maybe that is why I don’t get enough sleep).

                        

                   Pat, Peg, and I                    Pat Enjoying the BNSF Model Train

I also have a number of younger cousins who I enjoy spending time with. They are all intelligent and great kids in their own respects and I cannot wait to see where life takes them!

Megan and I. One of the super talented cousins I mentioned

The Future

Speaking of life and where it takes you, I find myself so grateful that I have stumbled into a life and job that I enjoy so much. And this gets me thinking about what will happen when Warren and Charlie are no longer with us.

What will that mean? Will there still be this Woodstock of Capitalists? Berkshire will no doubt continue to be one of the greatest companies in the world. A true testament to Warren and Charlie's design. But, what will happen with the Annual Meeting? Will it die off, and will these few amazing years I got to enjoy become a distant but extraordinary memory? I do not know, and I really don’t like thinking about it.

But, what I do know is that I will enjoy every moment of how ever many meetings we have left. Because when I am older I know that I will dearly miss these very special days on the first weekend in May.

Top 10 Books From 2014!

Last year I was very interested in business biographies because I enjoy learning about the history and culture of various companies. As an investor, it is important to read a lot and absorb as much quality information as you can. Unfortunately, we don’t have a position in any of the companies in these books. But, I would love to own many of them at the right price.

What was most interesting to me about this group of books wasn't the business strategy reasons for why these companies were successful or not, but rather the morals behind the people.  It is amazing what people can create with good morals and a lot of hard work. And on the other side of that coin, how destructive people can be without the right morals. The first book does a great job of exploring that moral cliff that we all face at times in our life. Below, I give a short synopsis and some thoughts on the 10 favorite books I read in 2014.

1. The Education of a Value Investor-Guy Spier

This was by far the best book I read about investing and life in 2014, in part, because I find my story very similar to his. It is pretty rare that you see someone do such a good job at analyzing themselves and correcting errors in their life and thinking. Guy started out working as an Investment Banker and he found himself questioning the morals of himself and the business. He was very unhappy and seemed lost in life for a brief time. 

Fortunately, he stumbled across Warren Buffett’s writings and it was like a light switched on! Here was someone whose morals were unquestioned and created tremendous value for people in the world of finance. Not long after, Guy started an Investment Partnership similar to Buffett’s early ones and it has been extremely successful.

Guy explains his investing and life journey wonderfully. In the end it has made him a great investor and an even better person. I can attest to this from some correspondence with him in which he has sent me some very nice notes, a Garmin GPS for cycling, and some tasty chocolates for the Holidays. And I haven’t even met him! In addition, Guy is such a great “guy” that he sent me one of my favorite books of the year and the next one on my list.

2. The Art of Thinking Clearly-Rolf Debelli

In this book Rolf Debelli explains what he calls cognitive biases or simple errors that all of us make in day-to-day thinking. The book was arranged in short three to five page chapters that all told stories and provided examples of errors in our thinking. For example, Chapter 91 talked about the Planning Fallacy. Most people make some sort of to-do list each morning or week. But, how often do those lists get completely finished or checked off? If you are like most people, you will finish the list only very rarely. That is just an example of us not being able to complete as much as we think we can. As an investor I have to try and deal with many of these biases each day, but since I recognize that, I think I am better equipped to deal with them. It can only help to understand the errors in your thinking and I can’t suggest this book enough!

3. Sam Walton- Made in America-Sam Walton

This is just such a wonderful autobiography where Sam and some of his friends and family really let you into his thinking in business. We all know what Wal-Mart has become, but the story of how it has become the biggest retailer is absolutely incredible.

I’ve never heard of someone experimenting, making mistakes, and improving day in and day out like Sam did. Surprisingly, Sam didn’t open his first Wal-Mart until he was 44 years old. Pretty amazing, seeing that most super wealthy people come across their big idea much earlier in life. Think of Bill Gates, Mark Zuckerburg, or Warren Buffett for instance. But, by the time Sam started his first Wal-Mart he had 20 years of experience learning the craft of retailing. He was constantly experimenting with new things, such as “self-service” shopping, new products, and store sizes. He just kept failing and keeping what worked.

When he opened his first Wal-Mart he was the largest independent variety store owner in the US (Ben Franklin type stores). While most people would consider this quite a success and rest on their laurels, Sam could not. From his numerous trips around the country he noticed that the large discount store was the wave of the future. So he borrowed everything he could and started his first Wal-Mart store. Obviously it was successful and he just kept doing it over and over.  He crushed his much larger competitors like Woolworths and Sears. It seems so unlikely that some guy from Northwest Arkansas would be so successful, considering all of the advantages the larger established stores had against him. But, this book shows that it was no fluke, and by working hard you truly do create your own luck.

4. The Everything Store: Jeff Bezos and the Age of Amazon-Brad Stone

Even though Jeff Bezos and Amazon did not cooperate in the writing of the book, the author did a tremendous job finding other sources to help create it. I read The Everything Store just after Sam Walton’s book and I could help but be reminded of Sam (maybe that is just a cognitive bias). Like Sam, Jeff started Amazon and just focused on what worked, books. But he was not satisfied with that so he kept experimenting, failing, and keeping what worked. Also, like Wal-Mart and Sam, Amazon has found a formula for success in retailing. Provide great customer service and deliver tremendous value to the customer and then just keep doing it again and again. The results, Amazon is crushing the brick and mortar retail store competition and seems to only get better year after year. I believe that Amazon will be tremendously huge company 10 years from now and this book will definitely help you understand why.

5. Delivering Happiness -Tony Hsieh

Tony Hsieh started the wildly successful advertising network company LinkExchange. The great thing about the book is not about becoming wealthy but about enjoying work and your life. LinkExchange was a lot of fun for Tony in the beginning, but near the end he didn’t know a lot of people that he worked with and the culture seemed lost. He resented going to work and he hated the situation he was in. So, he and his team decided to sell to Microsoft for $265 Million! Tony was just 26 and very wealthy but the whole experience of hating going to work bothered him.

After he sold LinkExchange he helped form the even more wildly successful company Zappos.com in his image to deliver happiness to all stakeholders. Tony has implemented so many fantastic things for his employees, customers, and vendors to create his image of what a company should be, and it is truly amazing.  Surprisingly, Tony sold Zappos.com to Amazon! But, he sold with an agreement that Zappos would be left alone to have their own culture and it has worked tremendously well for both Zappos and Amazon.

6. Cable Cowboys- Mark Robichaux

There must be something to making onto the Forbes 400 list and Cable Cowboys explains John Malone’s life journey in the Cable and Media Industry.  In 1972, John started as CEO of Tele-Communications (TCI), a cable company with about $2 Million in revenues and on the verge of bankruptcy. By 1981, after an absolutely incredible amount of deals, he had created the largest cable company in the US! In 1998, he finally sold TCI to AT&T for $32 Billion in stock.

Now it appears Malone is pulling out the old TCI playbook again and consolidating the Cable Industry in Europe with his company Liberty Global. Cable Cowboys does a wonderful job of explaining the TCI playbook. What I find interesting is that the TCI strategy is very similar to what Amazon does!  Malone does not concern himself with Net Income, but rather Cash Flows and avoiding taxes in every legal way possible. His business deals are known for being some of the most complex, but compared to other large companies his have paid some of the least amount of income taxes in the last 40 years.

7. The Partnership: The Making of Goldman Sachs- Charles D. Ellis

The Partnership gives the complete history of the most respected investment bank, Goldman Sachs. It was very interesting to learn how the small partnership started out, struggled at times and then grew into the behemoth investment bank that it is today. The most interesting part for me was learning about how the leaders of the firm acted when it was a partnership and how things gradually changed once it became a public company and mostly owned by outside investors. If Goldman stayed a partnership it would be interesting to see how they would have behaved in the 08-09 financial crisis compared to other public investment banks.

8. Flash Boys- Michael Lewis

This was one of the most controversial books of 2014, authored by who I think is the best financial industry author. Michael Lewis always tells a good story and explains complex subjects extremely well to his readers. Flash Boys addresses the issue of High Frequency Trading firms front-running other investors orders. By using a variety of questionable techniques HFT firms and their algorithms are able to glimpse orders of other investors and then react to them. This allows them to make a slim profit, and when this is done millions of times it adds up to serious money. The book explains how Brad Katsuyama, a trader with the Royal Bank of Canada, pieced together the HFT world and sought to fix it. His solution was starting the Investor’s Marketplace (IEX), which Delphi Value Investments happily routes its trades through. I can’t recommend this book enough.

9. The Frackers- Greg Zuckerman

The oil revolution happening in the US has been incredible and The Frackers explores the stories of the executives and companies involved in these unconventional oil plays. Zuckerman explains how it took years and tons of experimenting for George Mitchell to perfect hydraulic fracturing in the Barnett Shale in North Texas. Following his success, a whole cast of other oil companies, led by some eccentric CEO’s, used these techniques on new formations all around the US. Since 2008 this has increased US oil production from 5 Million Barrels per day in 2008 to 9 Million in 2009! This is by far the most interesting book I have read about the oil industry.

10. Final Accounting: Ambition, Greed, and the Fall of Arthur Anderson- Barbara Ley

I still remember watching the news of Arthur Anderson and Enron collapsing. I was just a kid and didn't really know what it meant, but I noticed the utter shock and horror from people. So of course, I was intrigued to hear the story of how the most respected accounting firm slowly changed into the worst. The book really shows how the power of incentives, bad leadership, and greed can lead to terrible outcomes. I think that one can learn many lessons from this book.

Amazon Actually Makes Money! : A lot of it

How is it that a business can increase sales from $609 million in 1998, to $89 billion in 2014 without making any money? How can a business go from having 3 distribution centers in 1998 to 131 all around the world today without making any money? Well, it turns out Amazon actually does make money. A lot of it! You just need to count the cash.

If you are like me, for years you have heard that Amazon does not make any money. And indeed they do not make much on a net income basis. On the other side of that coin, there is quite a history of companies making a lot of money on a net income basis when there were really no earnings at all (Enron, Worldcom, etc.).

Isn't it interesting that the first consolidated financial statement that Amazon lists in their 10-K(Annual Report) is their cash flow statement? There are almost NO other companies out there that do this. Normally, the income statement or balance sheet comes first. What is Amazon’s management focused on? Maybe on generating more cash? We strongly believe that they are.

At Delphi Value Investments we analyze companies profitability based on their Owner Earnings (OE). Put very simply, that is the cash the business generates (cash from operations) minus the capital expenditures it takes to maintain the business’ competitive position (Maintenance Capex.). So for Amazon, that Maintenance Capex accounts mostly for keeping its computer systems up to date and repairing the fulfillment centers it currently has. Any new fulfillment centers would be considered Growth Capex because those new warehouses will be used to grow new sales and profits.

In 1998, Amazon had sales of $609 million and showed a net loss of $124.5 million. But, things were not as bad as they seemed. The business generated $31 million in cash from operating activities and spent $28.3 million on capital expenditures. As I noted above, all of this capex was probably not for maintenance. Much of it was being used to grow. We estimate about 50% was used for maintenance or about $14 million. This is also relatively close to the depreciation charge of $9.6 million. On this basis, in 1998 Amazon had around $17 million in owner earnings. Not bad for a new company!

Now let’s fast forward to 2005. By this time Amazon had about 18 fulfillment centers around the world. Amazon’s sales were $8.4 billion and net income was $359 million. The business had cash from operations of $733 million, but capital expenditures of just $204 million. Again, it is hard to estimate how much of that is maintenance and growth but let’s just assume 50% again. That means that Amazon had profits (OE) of $631 million!

Since 2005, Amazon has continued to grow like crazy! They have entered new businesses like Amazon Web Services and Kindle, and they have added thousands of new items to their fulfillment centers. In addition, they have built around 110 new fulfillment centers. The company now has 131 fulfillment centers and a large number of data centers for Amazon Web Services (the number proved elusive). With all of these new business ventures one would expect capital expenditures to increase significantly, and they did.

In 2014, Amazon had $89 billion in sales with a net loss of $241 Million. However, as before, the cash tells a different story. Cash from operations came in at $6.8 billion with capex being $4.8 billion. Because Amazon does not break out how they spend their capital expenditures it is VERY difficult to get a precise measurement of maintenance capex, but, it is still plainly obvious that a lot of their capex is for growing the business.

Jeff Bezos could very easily decide today that he didn't want to add any more fulfillment or data centers and just make do with the assets Amazon already has in place. We would then see a significant decrease in capital expenditures (we would guess around $1 billion). Without the new capital expenditure spending we would see the depreciation charge stay roughly the same. I strongly suspect sales would increase, but at a slightly lower rate than the last few years. There are two main reasons we believe this to be true. First, Amazon is becoming more popular with its customers and we believe this will naturally increase sales. Secondly, some of the new fulfillment and data centers were not operational during all of 2014. There will be some benefit to having these new assets fully operational in 2015. Since sales would grow and depreciation would stay steady we would begin to see higher net income. We would also see higher income taxes and the financial news networks announcing that Amazon is now massively profitable (this last part is pure speculation on the authors’ part)!

Obviously, Jeff is too smart to do this because he believes, and we agree, that new investments offer a very high rate of return for Amazon (and very little income taxes). In 2011, Amazon had 80 fulfillment centers and now they have 131. I suspect that around 30% of capex in 2014 went to building the new fulfillment centers (Growth Capex). I do not have a good estimate for the capital expenditures for Amazon Web Services. For 2014, my estimate for maintenance capex is around $3.5 Billion. This brings us to an owner earnings figure of $3.3 billion for 2014. That means that since 2005, Amazon has grown our estimate of OE by an average 46.9% per year!

Unfortunately, we will not be buying Amazon’s stock for two reasons. The first and the largest reason is that the stock price is WAY too high for our tastes. The market currently values the business at $171 billion (Market Cap). We do not like the prospect of paying $171 for a business to receive $3.30 in profits. If we think about that in terms of a bond, that bond will pay us 1.9% initially, and will grow significantly in the future as the business grows. 1.9% is just not cheap or interesting enough for us, even for a business as great as Amazon. Now, if I had to choose only between a 30 year Treasury, paying 2.73% or Amazon at 1.9%, I would take Amazon stock any day. Fortunately, we have thousands of other companies to look at.

We hope that at some point in the future the stock price comes down to a more rational level. This may never happen, and that is just fine.The second reason is that we had to make a lot of “rough” assumptions to get to our owner earnings figure. We like to have better estimates of maintenance capex when we purchase shares in company. If we took the time, I feel that we could likely get a better figure for that. But, since the stock price is nowhere close to interesting for us we will just move on.

Full Disclosure: No position in AMZN