Steven Wood is the founder of GreenWood Investors, a New York City based investment firm specializing in deep value investments resulting from extreme pessimism, structural inefficiencies, and low competition. GreenWood was founded on the belief that investors should have a long-term orientation and transparency into their holdings and has focused on a collaborative approach to investing, sharing ideas, and posting portions of their research on their website.
We recently had a wide-ranging discussion that included how Steven got his start in the investment industry, why he looks to invest in builders, and why Europe is among the most attractive places in the world to hunt for bargains. He also discusses his investments in CTT (OTCPK:CTTOF), Bollore (OTCPK:BOIVF), Exor (OTCPK:EXXRF), and Rolls-Royce (OTCPK:RYCEF).
As you can discover from reading the transcript of our conversation, Steven is constantly brimming with ideas and has a mind that is always scanning the world to find the underlying connections that others might have missed.
Ohio Capital Ideas: Thanks so much for agreeing to speak to me. I’m deeply appreciative. I’ve just so much enjoyed reading your letters and your research. I just wanted to start off and ask a little bit about the background of GreenWood. I was wondering if you could talk a little bit about the genesis of GreenWood and maybe some of the investors who you look to for inspiration.
Steven Wood:I was working for this guy named Wally Carucci, who more people should know about honestly, but he didn’t care about publicity. So, he never really was out there. But the people he knew… so like here’s a letter I have from Buffett and the only reason why he took the time to respond is because of Wally frankly, not because of me. Wally’s dad, Joe Carucci, started Carr Securities who was a prime broker to Graham Newman, Ben Graham’s fund. Tweedy, Browne (AMG) and Carr Securities were the two prime brokers for Graham Newman. Tweedy migrated into asset management fifty-years ago and has a viable business. Carr never did. But, as a broker-dealer continued to be relevant to investors who were descendants of Ben Graham.
Buffett did an internship at Carr Securities. They used to own 20,000 Class A shares of Berkshire (BRK.A)(BRK.B) at a $7 cost basis, the same cost basis as Buffett, because they were all trading net-net’s at the time.
So if I just fast-forward, I accidentally fell into Wally’s lap looking for a job right at the bottom in March 2009. He said, “sure I’ll introduce you to all these amazing people, but I need help right now.” I was buying Ford (F), he was buying General Growth Properties (BPY), it was kind of a crazy time. And so I basically just started working with Wally for free because there was so much work to do and it was really cool work. Wally and I became almost father and son, but the problem was that there was no future in the broker-dealer business.And so I asked if I could build Carr into an asset management business or do something else? That was in mid-2010, about fifteen months after meeting him, and he wasn’t at the level of comfort with me where he would completely trust me with his family’s name. So, we decided to form a separate asset management company and I was going to give him half and start a track record and see how it goes. And that was GreenWood Investors. It turned out I could only give him 24.9% because if I gave him more I would have had to regulate his activity and he owned five-hundred securities.
Wally died in 2013 and at the time I had $2 million of assets under management, or maybe $2.5 million, something in the low single digits, and I had met all of Wally’s friends and a tremendous amount of people over those last four years. I didn’t see myself identifying with many other people, though. Honestly, I had figured out through patchwork an investing style that was really quite different. It was a combination of Munger and of John Mackey’s Conscious Capitalism and a lot of the European family holding companies with investors that I ended up becoming almost friends with. If you juxtapose how Fiat (FCAU) is run versus GM (GM)…I just wholeheartedly agree with how Sergio [Marchionne] was running that business and I couldn’t believe that GM wouldn’t even talk about a merger, wouldn’t even consider it.
But, the really cool thing about you and I not having the provenance of certain career paths is we don’t say “just take my word for it.” You let the research speak for itself. Wally was big on that as well. He also happened to know the best portfolio managers in every industry, so you could call other really smart people and ask them what they like and don’t like about particular ideas. It’s the best collaborative approach possible. That’s why I write research and why we’re collaborative, because I’ve seen it work so masterfully and it’s very different from the traditional Wall Street approach where people in very fancy offices act like they are giving you the word of God when they write their letters. I think if you’re worth however many millions or billions, enough to invest in these funds, you’re probably smarter than the average person managing money and you know how to build commercial businesses, right? Instead of the funds telling the partners what they think, the partners should be able to offer contrary points of view and play a role in the process.
OCI: So, almost a modified crowd-sourcing approach filtered through some intelligence.
SW: And as Wally would say, you don’t always want people agreeing with you. It’s actually the opposite.
OCI: You’ve talked a lot in your letters about the concept of builders.Could you expound on that a little bit and give a precise definition of what it means to be a builder? And how do you spot them when you’re researching companies?
SW: I haven’t really come up with a precise definition, but it’s someone who has a lot of skin in the game. Did you, by chance, listen to Exor’s Investor Day last fall?
OCI: Probably, but I don’t remember that one now. I listened to the one they had recently.
SW: Perfect. So, they talked about dichotomies a lot…being both patient and aggressive. A builder is someone who, in my opinion, can balance short-term and long-term. In my first quarter letter I wrote about the amygdala and the prefrontal cortex. With the builders, it’s not one or the other, it’s both. What I mean by that is there are people who have extremely high IQ’s or they are extremely artistic but have no commercial awareness or savviness. You can contrast those people with the perfect salesperson, who doesn’t intellectualize anything, because it’s all EQ. It’s like Donald Trump. He’s a very extreme version of this, but Donald Trump is 100% amygdala. He knows how to absolutely crush it on the debate stage and with audiences and how he can create these memorable nicknames for his opponents. But, there’s no prefrontal.
One of the things I don’t like about Wall Street is how it professes to create value, but really the managers of those businesses are creating value and you just happened to pick the right ones, which is a service to be able to do that, but you didn’t expand the pie at all. The builders are the ones who expand the pie consistently. Value creation comes from the prefrontal cortex, this patient, deliberate, thoughtful part of our brains. But, value to the consumer often comes from the emotional part of our brains, dominated by the amygdala. So, if you think about the incredible value creators of all time, they exhibit deferred gratification to give instant gratification.
OCI: Who today would you consider to be a great builder?
SW: There’s a wide range. Buffett is clearly one. He comes in from a very interesting perspective. Bernard Arnault is one. Vincent Bollore, I know you published recently on Bollore. I think Elkann is an emerging builder and I think his great-grandfather was clearly one. At one point 25% of Italy’s economy was Fiat, so basically he built the modern Italian economy.
I think the founders of Netflix (NFLX) are great builders. I really enjoyed Mark Randolph’s book and Mark is really good at getting something from zero to one-hundred.
Walt Disney (DIS) is someone else I hugely admire, he and Roy Disney, his brother, they were both builders. A book was recommended to me called Powers of Two. I listened to that book while I was thinking about this thesis on builders and you can see it in action within some of these great collaborations, one person in a partnership is stronger in one part of the brain than the other. Back to my thesis on the builders, they are strong in both and it’s a rare combination.
OCI: Yeah, it’s by Joshua Wolf Shenk. It’s a great book. He wrote another book that was very good called Lincoln’s Melancholy, about how suffering and depression helped form Lincoln’s character. Shenk is a really terrific author.
SW: So, I mean we could keep going through examples, but you know, related to what you’ve written on Seeking Alpha, Vincent Bollore is a great builder. He’s clearly a builder and clearly does not care about the near-term consequences of his actions or how others perceive him.
OCI: Shifting gears a little, I wanted to ask you about another concept that you have written about, which is trying to get as broad of a sense of a company as you can, specifically by looking at things like net promoter scores and employees’ reviews on Glassdoor. I think net promoter score was a big factor in your Peloton (PTON) investment. But, I was just wondering if you could talk on how you bring those factors into the investment process.
SW: It’s a good question because it’s really not a science. You could be tempted to look at a net promoter score and a Glassdoor rating and maybe a supplier satisfaction survey or whatever and cobble together some algorithm to trade this. Unfortunately, it’s not that easy and I can give you so many examples of why, but just look at Sprint (TMUS) and Verizon (VZ). If you go to Sprint’s campus in Overland Park, Kansas, everyone is happy and everything is moving at this leisurely pace and if you go to Verizon’s campus in New York City it’s just ruthless and aggressive and everything is just the opposite. You don’t always want a happy go lucky sort of Stepford workplace and this is a perfect example of that.
Or take someone like Sir Martin Sorrell who is infamous for working around the clock, like if you send him an email at 3 a.m. he is probably going to get back to you within an hour. You would think that working for someone like that has to be exhausting, but actually his employees love him and same thing with Sergio Marchionne. Sergio never slept. He was managing three to four businesses at one time. At one point he was the Vice Chairman of UBS (UBS), Chairman of SGS (OTCPK:SGSOY), CEO of Fiat Chrysler, of Ferrari (RACE), Chairman of CNH (CNHI). And after he died we got some feedback from his teams that the intensity had faded somewhat. Think about that. One person managing like six different organizations was so intense that after he left and all these businesses had their own managers, the intensity fell. There was a joke that if you went to work for Sergio you’re going to get a divorce in the next few years, because you’re never going to see your wife. But, those guys loved working for Sergio, because Sergio demanded their best in a way that was sort of like your dad demanding the best from you. I hate to say it, because it sounds corny, but it’s actually a sign of love that they believe in you.
I’m on the board of CTT in Portugal, the postal operator, and when we have strong disagreements and we have debates, everybody knows it’s in good faith. It’s like, don’t take this personally that I voted that down,I just know we’re capable of better. Most boards don’t care to that level. They do care, just not so much that they’re willing to continue to disagree. People just make their points and then it’s over.
So, yes the net promoter score and employee reviews and other things are important, but the real dynamic is what matters inside a company and simple scores have trouble completely capturing that.
I think it’s why founder-led businesses often have the best builders. Family controlled businesses tend to operate the same way. They really care about their people, whereas so many Fortune 500 companies can get depersonalized and relationships can get transactional and they stop being relevant to either the employee or the customer. So, I’m looking for employee engagement where the employees are not just happy because they are not expected to work that much. It’s more a question of whether the employees are happy because the company is mission oriented and whether every employee individually has a mission.
We short Boeing (BA) well before COVID.
SW: Well, it’s not quite a happy victory quite frankly. But, the market wasn’t really all that concerned with the crashes, all they cared about was free cash flow. The view was, well, those planes are still needed, so it doesn’t matter that much.
I actually had to look way, way back at their mission, because their mission statement kept changing over the years. After the second 737 Max reaction, I think they did change it to include safety, to say that safety was a priority. But, maybe two weeks before they did their mission statement, the word safety was probably mentioned, but it was a five paragraph thing that probably Bain & Company or another consultant wrote for them and that wasn’t at all being filtered through how people were acting on a daily basis. That can be hard for investors to see, because contrast that with a Honeywell (HON) under David Cote where it wasn’t founder-led. It wasn’t like a family-owned company, you know, there’s no reason why you would have thought that this could have been a really awesome purpose driven business, but it was, because the CEO was so focused. It’s just that normally a large shareholder or founder makes that culture more likely.
For example, at CTT, another board member and I, we converse on WhatsApp at like 11 p.m. their time on a Saturday night about possible partnerships and things. So, here’s a guy who’s relaxing at home thinking about ways that the company can explore value creation on a Saturday night at 11 p.m. That’s what skin in the game buys you.
OCI: I wanted to ask you about geography. A lot of your published research has been focused on European companies. I’m not sure how much of your portfolio is invested in Europe right now…
SW: It’s about one-third in Europe.
OCI: OK. Is that a result of that part of the world simply being cheap or do you feel you have an edge investing in Europe? And as you invest outside the U.S., how do you think about currencies, political risk, etc. versus staying domestic?
SW: Really great question. That is definitely a sixty minute conversation.
I invested in Europe by mistake because the Ford playbook that worked really well for us, I saw being enacted at Fiat and so I got involved with Fiat in 2011. Getting involved with Fiat then implied a significant amount of country analysis. I’ve been investing there since then and I do go over there all the time and I think there are two main reasons.
It’s less competitive. So, it’s easier to find opportunities. There are some big opportunities there. Also, even more than the U.S., it’s a pro-momentum market. Most of the capital that gets allocated to Europe is in what’s called UCITS funds. These people want to outperform the index by 10-20 bps and that’s a great year for them. There are no contrarian investors in Europe, almost none. But, then the management teams are deeply contrarian. I find in Italy, in particular, that there are great value-add managers. They think about value creation in a very Western sense. I mean, it’s not a mistake that Luxottica’s (OTCPK:LUXTY) CEO is Italian, Walgreen Boots Alliance’s (WBA) CEO is Italian.
OCI: Sorry, to interrupt you, but that’s very interesting. Some cultures within Europe, particularly southern Europe in Italy and Spain, have much more family oriented cultures. There are some countries where family is just much more central to the culture than perhaps it is in Anglo-American culture. Do you find that cultural difference makes a big difference in how companies are managed in those countries?
SW: Absolutely. Now, the really cool thing about Italy is, northern Italians, versus southern Italians, that they challenge the status quo. They’re systematic. I think that, yes, they are family oriented, they do take care of their people. Fiat has been consistently criticized for not closing more Italian factories and they have said “no, we have some brands that we can actually invest in and that’s a better use of our capital than just paying someone to leave the company.”
When you talk to Italian management teams, it’s very rare to ever hear someone ask a “gotcha” question, like “why are you doing this?” They’ve already challenged all of that internally and think very systematically.
But, going back to Europe in general, there are more targets and less competition, particularly contrarian competition. And the second thing is that you can get a competitive advantage over the remaining investors so easily. For instance, particularly in Italy, Spain, Portugal, even France, most businesses are not publicly listed. But, it doesn’t mean they don’t like talking to investors. In fact, I find management teams like talking to investors a lot because it’s a very thoughtful process. They want to hear what we think because we are exposed to the daily grind of markets all the time.
Here in the United States I feel like everything is just boiled down to GLG networks or expert network phone calls. I don’t find that to be the case in Europe. I can very quickly through LinkedIn or through my own network find someone at a high level at any company that I need.
OCI: The big thing with Europe that’s in the back of people’s minds is what happens if the Eurozone were to break up. It’s probably not a high probability event, but chances have certainly risen in recent years. How do you incorporate that probability? Do you look at how resilient certain companies would be in that scenario? Or is this something you don’t think about a lot in building investment cases, you just think about the microeconomics of the company?
SW: No, we think about it. I’ll share this with you. And I’m sorry, I’m being really reminded of Wally a lot today. I will never forget when we started buying Fiat in 2011 and the Italian bond yield was around 11%. This was within the first six months of my portfolio and I remember asking him, “What do you disagree with? Do you have any disagreements with what I’m doing?” And he said, “Why is Fiat only 5% of your portfolio right now?” I thought, oh well, there’s a ton of risks here. Italy could leave the Eurozone and this could be a disaster. He said, “What’s the bear case with Fiat? What’s the worst that could happen?” Worst case scenario was probably they spin out Ferrari, but at least we get Ferrari and I had confirmed in the bond indentures that that was completely doable. So, it was like, there’s your answer. The value of Ferrari was probably 4 billion at the time and the market cap of Fiat was 3.5 billion. The hedge was in the price.
CTT is kind of like a Fiat for us in the worst case scenario. Honestly, I don’t even see a worst case scenario for CTT. Even if Portugal leaves the Eurozone, we’re fine.But, you know even in a really weird scenario just in the value of the real estate we’re going to get all of our money back. There’s also a bank that’s in there for free and that’s worth 70% of the market cap today. So, we have assets that we can spin out if the core business ever becomes irreparable.
So, I do think about it. I just want to make sure in those events I don’t take a zero. With Exor or Bollore, or any of these holdings, a Eurozone breakup creates volatility for sure, but the value of Universal Music Group isn’t impaired in that scenario. Does Partner Re, a Bermuda reinsurer, change at all? Exor’s not even an Italian entity at this point.
In terms of managing foreign exchange, it’s almost the same as how I view the macro. I don’t really take many views on macro unless I’m very confident that the consensus is wrong. What does that mean? Pre-Brexit the polls were saying something like 45% support for Brexit and the market was saying something like a 99% chance it doesn’t happen. So, we hedged all of our currency the day before because the market was behaving so differently from reality.
I’ve generally done well managing our foreign exchange hedge book just by identifying those periods where consensus is saying only one scenario exists. Like when the euro was at $1.05 and the narrative was that it’s going to parity. So, we covered all of our hedges at that point. It’s not because I’m a good macro guy, it’s because every once in a while I will disagree with the prevailing view.
Honestly, I’m not at the same level of conviction on this, but if the Franco-German €750 billion COVID response package passes…
OCI: If the “Frugal Four” can get behind it…
SW: Yeah, exactly. And I think the way that the Commissioners set it up, they set it up for a compromise. So, if that goes through I think very suddenly the perma-bearishness on the Eurozone that pervades the world is going to have a reality check and you can have a very violent reaction because the European equity flows have just been consistently painful for the last three years and everyone is underweight Europe right now.
I’m gaining conviction right now. We’re not doing anything with that in our portfolio, but I was really nervous two months ago about the European response to COVID-19 in terms of European cohesion. But, when I saw the Franco-German proposal, I thought, wow, this is exactly what Hamilton did at the start of the United States of America.
OCI: Absolutely. It does seem to me that when you look at Europe, you kind of have two paths, and only two paths, that they can really go down. They’re either going to become more coordinated fiscally in the future, which can occur gradually, or the experiment is going to fail. I don’t really see a third option.
SW: And the failure hurts Germany the most and the “Frugal Four.”
OCI: Yeah, German exporters are the most vulnerable in a breakup scenario. The mark would be so much stronger than the euro.
SW: And you could say the same thing about the “Frugal Four.” Now, Merkel overtly understands this. I think a few years ago I was frustrated with where she was, but Merkel is all-in on Europe now. I totally agree with you. In the event where it becomes written on the wall that the euro is over, Italy’s going to sell off by 25% or 30% in one day and it is going to be the ultimate buying opportunity.
OCI: Because those Italian manufacturers are just going to thrive.
SW: They are going to print lira. It would be an amazing buying opportunity. Everyone forgets that when the euro was created, Germany was the sick man of Europe. It was struggling with very high labor costs and an uncompetitive wage dynamic. So, all they did was lock in all their competitors who were constantly devaluing their currencies against them. There is almost no difference in productivity levels between western Germany and northern Italy, except in Italy they used to have 10% depreciation every year of their currency.
OCI: I don’t know if you’re familiar with Edward Luce at the Financial Times. He wrote an interesting book called The Retreat of Western Liberalism. The populism that we’ve seen, certainly it’s spread throughout the world, but not as much in northern Europe. So, even if the Eurozone is in the best interests economically of a lot of countries, it’s still possible that a Marine Le Pen, or someone like her, could gain control of a government of France or of Germany and then all bets are off.
To me, some shift where populists gain more power is the only way that Europe does not gradually begin to coordinate more fiscally. So, the answer becomes how do you shift gradually towards more fiscal coordination, but do it in a way that it does not provoke backlashes in some countries and risk the entire European experiment.
SW: Yeah, unfortunately you have to do it crisis by crisis. You get pain before you get the benefits. Part of why voters are throwing hand grenades at the establishment globally is in some respects a revolt against the current version of the economic system that we have. I don’t even want to call it capitalism.
We’re long this Italian defense firm called Leonardo (OTCPK:FINMY) and I have a close friend that is there and she was saying that if you ever see our company win a major U.S. contract, this was before they figured out a work around, to sell our stock because under Italian law it is illegal for them to pay a level IV lobbyist to go get all the information on their competitors in terms of what their packages look like, which everyone does in America. So, Boeing and Lockheed (LMT) and all these people bid on contracts and they know exactly what everyone else is doing because they pay a little for a lobbyist to go demand to get all those details, which they can legally. It’s legalized corruption. The funny thing is that under Italian law, they’d all go to jail if they paid for a lobbyist to go get that information.
So, in some respects I empathize with the populists because it’s a sort of rejection of the current system that is fairly rigged and is honestly not a meritocracy any more.
OCI: Yeah, you have to find the right mix of federalism. You made the comparison to Hamilton, which is good, because Europeans can look to the United States as an example in many ways because we had the same negotiations. Earlier, the federal government was not as powerful and there is no reason you can’t have both the European Union and localism. It’s not either-or.
SW: Yeah, for sure. Just think about what 9/11 and COVID has done to us. Major expansions of the central government. We used to be a more locally governed population. We forget that for the first one hundred and fifty years pretty much every state did its own kind of thing.
OCI: When you invest in emerging markets, how does the analysis shift? Are there places where you just won’t invest? Do you just adjust the discount rate, the more you perceive the country’s risk to be, the higher the currency and political risk?
SW: That’s a really good question too. I don’t want to say no to anything. I will buy anything at a specific price. There was one restaurant business in China that we came within striking distance of buying right before COVID-19. It’s owner-operated and it was at 5x earnings. We were going to actually go to the restaurants and get a first-hand view of the company outright. That, to me, is something that’s appealing even with the China risk.
Buying something like Tencent (OTCPK:TCEHY) at its valuation, with the VIE problems, and the fact that they are basically complicit with the Chinese Communist Party. I just don’t think that those are baked into the price.
OCI: I wanted to ask you about a couple of specific companies I know you own. Bollore is one. We don’t need to go through the whole thesis, because I would encourage people to view the research that you have posted on your website. Just wanted to get your thoughts on Bollore now, where there is a disconnect between the gross and net shares outstanding. What are your thoughts on L’Odet (OTCPK:FCODF)? Are we at a point where that gets taken out soon?
SW: Yeah, because the squeeze-out law was recently changed so that you can squeeze out minority shareholders if you own 90% of shares instead of 95%. That being said, I don’t own any of these HoldCos for the discount to go down. We only like them when we like the underlying assets. I think that you’re buying Universal Music Group at transaction value with an IPO coming in the next three years and you get Canal Plus and Telecom Italia (TI) and all the other assets for free. And actually, if you buy Bollore, you’re getting more Vivendi (OTCPK:VIVHY) relative to your investment than if you buy Vivendi. So, it’s a levered bet on Vivendi, which is also kind of a levered bet on Universal Music Group and then you also get African ports for free. I don’t know if the geopolitical environment is such that China would buy those ports, but I do know that those ports are a very valuable asset.
OCI: And their freight forwarding business is decent as well.
SW: And I think you just saw yesterday or the day before. DSV (OTCPK:DSDVY) talked about how they’re seeing very high freight forwarding rates because there’s no capacity anywhere. So, actually the freight forwarding business is not bad right now.
OCI: I have a similar view generally to you. I’ve written a lot about Exor over time and I’ve owned it for about five years now and was attracted to it because I just think John Elkann is a really quality guy and, like you, I really admired Sergio Marchionne. I’ve always said not to look at the discount and assume that because it’s trading for a discount to net asset value that it’s automatically cheap so go buy it hand over fist.
I do think in the case of something like Exor, there isn’t much of an economic reason why it should be trading at such large discounts to net asset value of 30% or 35%. I mean holding costs are incredibly low.
SW: Yeah, and what about no capital gains taxes?
OCI: No capital gains taxes because of the participation exemption in the Netherlands, which I’ve explained to people multiple times. So, there’s no taxes at the holding company level.
SW: And the reason for that, by the way, is that they don’t have LLC’s, so in order to avoid double taxation, they have to have the participation exemption.
OCI: And there’s not this, what I would call maybe ITT disease or Valeant (BHC) disease. John Elkann does not have this self-aggrandizing gene or empire builder gene. And yes, you give up control to Elkann and the Agnelli family, but you know, you give up control with every investment. I do not have the capacity as an investor to buy 10% or 20% of a company, so I’m always giving up control to either management or another large owner.
SW: What you said right there is the most important thing. You are always giving up control to somebody. Do you want that person to be someone with their entire net worth invested alongside you or someone who owns nothing and just has a few stock options?
OCI: Somebody could persuade me there’s a legitimate justification for a 5%-10% discount, but I don’t see an economic justification beyond that. But, it’s always existed. It may always exist. So, you’ve got to look at where these things have historically traded and just make sure you don’t buy it above a relatively normal price relative to net asset value. With Exor, the history is something like a 20%-40% discount, so I think people just need to look for discounts closer to 40% before buying.
SW: It tightened up to like 5% before the Partner Re deal. The market did not like the Partner Re deal.
The thing that matters the most is the underlying compounding. With the exception of Canal Plus, everything in the Bollore enterprise is set to compound at a CAGR of over 20%. And you’re buying it at an all-time wide discount right now, which doesn’t hurt. And, yes, I do have the view that there’s an increasing likelihood that they collapse the share structure. Would I advise people to buy Bollore because of that? Absolutely not, because you could be waiting for three more years, but I think the probability of them collapsing the share structure over the next twelve months went from 2% to probably 40% in the last three months. So, it goes back a little to our conversation on macro factors. I do know that the market is valuing this at a very wide discount and I have a view that the probability of the collapse just increased substantially, so yes, we bought more Bollore just a couple weeks ago because I just disagree with the current sentiment on it.
Because of our collaborative approach, I hear from other investors and they share their emotional points of view because they know what we own. When Bollore didn’t bounce off the COVID bottom, everyone hated it, which was interesting because which of their businesses is really affected? Maybe freight forwarding, African ports. Nothing else is really affected. And, by the way, African ports have a 40% capacity expansion happening this year and next. Even oil and gas is manageable because it’s not a very huge portion after they did the drawdown in 2014-2015.
There was no real reason aside from the fact that the stock hadn’t bounced, which was frustrating, to not love Bollore. Anyways, they’ve been buying back stock and the really beautiful thing about the buybacks is that according to our calculations Vincent has control of Bollore, even if you collapse the share structure. He has over 50% of the shares. We’ll see. Don’t hang your thesis on it, but there’s a chance the collapse could happen in the next twelve months. I think there’s about a 40% chance.
It’s kind of like Rolls-Royce. I think there’s a 60% probability that they monopolize the wide body space in the next twelve months. But, I like it for more than just that reason. I haven’t talked about that publicly because, you know, I honestly don’t want that in the price. I want the price to not reflect that.
OCI: If I was John Elkann or Vincent Bollore, part of me would want the stock price to reflect reality, but another big part of me wouldn’t want that to happen just because share buybacks are so accretive for both organizations. They can create a lot of value for remaining shareholders, including their own families.
SW: And that is the definition of a builder. They’re not managing this for the next quarter. Sell side analysts don’t like them, maybe with the exception of Elkann. But, I don’t think anyone likes Vincent Bollore on the sell side. Because he doesn’t care what they want to see happen in the next three months.
OCI: Sell side analysts tend to like you based on the information you feed them and how easy you make it for them to model and I don’t think he cares about that.
SW: Yeah, that’s a really good point, actually, and when I’ve seen opportunities they’ve tended to be when you enter into a non-guided territory. That tends to be the case in Europe. European sell-side has a history of just being spoon fed information directly from the company. It was legal up until maybe ten years ago to just literally give them the numbers and that sell side analyst was basically your IR department. And so when you have a company withdraw guidance or not give guidance, that’s going to be particularly inefficient. And no surprise, Exor and Bollore don’t give guidance. Whereas if you follow a normal company they give you at least a little whisper what to put in your models.
OCI: Which is so counterintuitive because the most valuable sell-side research would be for companies who don’t themselves give guidance.
SW: That’s funny. I’ve actually never thought about that. I’m writing it down and attributing it to you.
OCI: You mentioned Rolls-Royce. It was the last company I wanted to ask you about because it’s also one that I own. I actually only owned it after reading your research. I just think you hit the ball out of the park on how cheap it is right now. Any changes in your thesis? When I hear criticism of the stock, it’s usually along the lines of the wide-body market being hit so hard and not potentially coming back for a long time.
SW: So, to be clear, I like all four engine makers.
OCI: Including GE (GE)?
SW: I love GE Aviation. David Joyce is one of the best CEO’s ever and it’s sad that he’s leaving and unfortunate he was passed over. But, I also love Larry Culp, who’s running GE now.
The jet engine business is a fantastic business. I think you have to compromise with the other three. What I mean by compromise is that you have to compromise on valuation and on management teams and on portfolio.
OCI: And balance sheet.
Rolls gets the penalty because it’s known as wide-body only. So, 35%-40% of the revenues are wide-body. Within GE, Safran, or Pratt & Whitney (RTX), there’s 40% of their businesses that I don’t want to touch either. I know that’s a terrible defense of a company. But, there are so many things that I love about Rolls-Royce even though we’ve lost money and it’s been a bad investment for us.
Warren East reminds me exactly of Sergio Marchionne. And in a weird way he has been consistently doubted by the sell-side for some reason. The mistrust of him is very high. He has these ambitious targets that the sell-side believes not achievable and not only is it still achievable, but they’re going to achieve them even if you only have a 50% normalization in traffic in wide-body for instance. I was with Warren East right before all the analysts came in for the full year 2019 results and he said he was talking to the CFO and he was just like,“when I came into this job, analysts told me if you get free cash flow to a billion, you’re stock will be in the mid-teens. Well here we are, we’re pretty much at a billion and the stock is at 6.”
The investment case has everything to do with where Rolls’ programs are at maturity. So, four years ago, 70% of their commercial aviation division revenues went through the deepest part of the cash burn cycle. These are forty-year, fifty-year cumulative cash curves. So, they just had 70% of their main business go through its biggest cash burn period and as those programs age, you just continue to climb that free cash flow curve.
Yes, they had a fixed cost issue and Warren East had to address that through £1.9 billion in OpEx removals, which is unbelievable. That’s partly because of COVID too.
OCI: I’ve actually thought that…I don’t know if there’s a problem with owning Precision Castparts, but I think it would be a great acquisition, if the British government would allow it, it would make a great acquisition target for Berkshire Hathaway.
SW: It’s perfect, because it has a twenty-year dependable cash runway.
Unfortunately with COVID, they did have to remove more costs to hit their free cash flow targets. One of my friends said to me, “they’re doing a terrible job of telling you the investment case.” But, it’s kind of inconvenient when you’re firing 30% of your civilian aviation workforce to talk about the medium term free cash flow targets. You can’t really do that. But, I think what was very telling is in the interview when they announced the job cuts, Warren East was very clear that they were not going to stop investing in the next generation technology. And that’s where the real interesting part of the upside comes from.
Boeing is going to have to develop a new 737. They’ll never sell more Max’s. We had that view pre-COVID and it’s just never going to happen. So, that order book is done by 2025. That new midsize airplane is going to become a new 737. Which is not great for Airbus (OTCPK:EADSF) because that means that Airbus is going to have to come up with a new A320 only ten years after the neo and so the capital intensity that was shifted over to the engine manufacturers over the last ten years is now all shifting back to the OEM. Well, not all. But, there will be a new 737, which will be a new opportunity for Rolls to enter the narrow-body space. I think there’s also going to be an opportunity for Rolls to monopolize the wide-body space on the 787.
Boeing and Airbus responded to the 9/11 attacks by introducing the 787 and the A350 to help stimulate new orders. So, the only way to actually build an order book was to have something newer, more efficient, something you can build a new fleet around. I don’t think you’re going to be able to fill an order book in the near future, in the next few years, with the amount of planes currently on the ground. The only way to rebuild your order book is to have something new, a next generation engine or aircraft. Rolls just so happens to have their UltraFan ready, by 2022 or 2023. They’re starting to do ground testing on the UltraFan this year, it hasn’t happened yet, but should soon. You only go to ground testing when you’ve locked in the design and it’s maybe one-and-a-half to two years away from being certified.
So, long story long, Boeing needs something to replenish the order book. The 787 orderbook was in trouble even before COVID and it’s gone by 2023. The question is, what does GE have up its sleeve with the GEnx? They don’t seem to have anything revolutionary such as an architectural change. They have mild adjustments to the architecture that can get you a percent here, a percent there. But, the UltraFan is a 10% improvement, because it’s a complete architectural shift. GE will not have that ready until the 2030s. So, you have this weird window that was going to happen before COVID, but is even more needed now, where Rolls might be the only engine on the 787. I’m not even sure that the market will love that when it happens, but when I talk that through with other investors in Rolls, their eyes widen and they say, “Oh my gosh, that’s kind of a game changer if you can monopolize the wide-body segment.”
If you do take one hundred percent of the market on the 787 it will cause about £600 million of dilution, but it’s OK because every year you’ve had incremental cash flow coming in as these programs mature, so, you can handle the dilution I think the reason why they just announced the major headcount restructuring is to not only preserve the UltraFan development program, but also to prepare for that dilution.
Even if you have the opportunity to win a 737, that’s more dilution on top because it’s a brand new program. It’s going to go through a negative free cash flow part of that program. The frustrating thing when you talk to Rolls’ bears is that they will always point to terrible free cash flow generation, but then they also get really concerned if OEM production comes down. They want the company to be taking market share, but they don’t understand just how expensive that is in this industry. This is the epitome of a deferred gratification business.
I’m not entirely sure what’s going to cause the market to wake up and realize…again COVID is a different situation and it will take some time for the market to normalize…but in a few years you’re going to have £1 per share of free cash flow and that should get a 25x or so multiple. Right now it’s at a 35% free cash flow yield on a forward looking basis. I don’t now when that’s going to happen that the market realizes that. I think the monopolization story could prove to be a very interesting narrative. What I do know is that Rolls-Royce is such a large company and followed by so many people that I don’t have to worry about that day not coming. I’d be more nervous if this was an Indonesian supplier or something that no one’s ever heard of. If you triple free cash flow, does the stock triple? I don’t know. Maybe.
OCI: If a tree falls in a forest and nobody…
SW: Exactly. With Rolls, they have to pay attention.
OCI: From a strategy perspective, should they consider getting back into the narrow-body market or is it more lucrative to just focus all of their resources on defending and entrenching themselves further in the wide-body market?
SW: I think you will see the company try and enter the narrow-body market, but what is more important is trying to monopolize the 787 program. To be clear, I have not spoken with Warren East on this. But, I think Rolls would first try to monopolize the wide-body market before moving into the narrow-body.
OCI: I don’t want to monopolize any more of your time. But, thank you very much. This was extremely enjoyable for me. I really appreciate you agreeing to speak to me.
SW: Absolutely. Thank you, man. Please stay in touch.
Disclosure: I am/we are long BOIVF, EXXRF, RYCEF, CTTOF, BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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