54958483 2011 Value Investing Congress Notes

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Ben Claremon: The Inoculated Investor 2011 Value Investing Congress Notes Day 1: Speaker #1: Seeing Value Through the Cloud Kian Ghazi- Hawkshaw Capital Management -

http://inoculatedinvestor.blogspot.com/

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Background (from Whitney Tilson) o Kian has been running this company for 10 years o Worked at Lehman brothers and is a Wharton MBA o Firm does some of the most extensive scuttlebutt research of anyone in this business Understanding how a manger thinks through his ideas is the most valuable part of attending the conference o As such, he is going to go really deep into a single idea Concentrated value portfolio with a focus on in-depth research Long short portfolio o Extensive primary research: calling customers and former employees to get insights into the industry o Trying to confirm or refute their variant view o They do not use paid networks o The majority of what they do is cold calls to proprietary contacts who are unpaid How do they invest? o They are value investors but their style goes beyond cheap business Look for high quality, one of a kind business. Does the business have a dominant market share, barriers to entry? Shown by return on capital (ROC) Rock solid balance sheet with excess cash and monetizable assets o Do a deep dive to try to see land mines before they step on them o Perform a pre-mortem on an investment If there is a permanent impairment to the earnings power, what might cause that? If they can think of a lot of these they will avoid investing o Invest in a business and not a stock Best Idea: Ingram Micro Inc. (IM) o Have talked to 25-30 industry contactsemployees, customers, competitors o Worlds largest IT distributor 1500 vendors and 180K value added resellers o $3B market cap, $35B in sales, trading .9x TBV and 10x EPS o Number one share worldwide

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Ben Claremon: The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

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Number 1 in the US and number 2 in Europe o Bear case: Commoditized service in a highly competitive, low margin business Mediocre returns on capital and thus the stock should trade at book value Shift to the cloud is a major headwind If Microsoft, Cisco and HP are trading at 10x earnings, then the middle man should trade at a lower multiple than those companies o Subtle industry tailwinds that the market does not understand Offers a cost effective sales channel to small to medium sized businesses (SMBs) Industry competitive dynamic is shifting toward a better environment Cloud fears are overblown Oligopoly is developing o Valuation Book value is a floor to the value Appraised the business at 100% upside over 2 years Why does this opportunity exist? o Threat of the cloud Uncertainty leads to an opportunity o Large cap tech is out of favor o Margins are at peak levels o Change in the industry is subtle What is the value of 2 tier distribution o Exists because they are the primary sales channel for selling tech into SMBs 8M SMBs These firms purchase 40% of all tech products sold o 30% are sold through 2 tier distribution Other 70% is sold direct or through the 1st tier o Cost effective sales channel o What is the value to the distributor? Cost effective sales channeloutsourced sales Dont need a large sales forcecost effective Choose to use this to reach SMB than direct Outsourced credit department o All outside billing and collections o One credit worthy company Outsourced training Distributor trains the value added reseller Help with troubleshooting o Industry Quotes Comes down to efficiency, logistics and scalemany companies dont want to manage sales o What is the value to the reseller? One stop shop: one place and one bill

Ben Claremon: The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

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This very important and some customers are willing to pay more for it Source of financingneed credit extended by the distributor Outsourced logistics and fulfillment Resellers do not have to hold any inventoryno warehouses If an order is placed by 5pm then the product is received the next day with labeling that says it comes from the reseller Support and expertise Conferences to help them understand trends o Realize that price is not everythingservice is very important Why is a rational oligopoly in the making? o 4 changes in the industry Key geographies have consolidatedless competition US: top 5 players have a 75% share o Top 3 do the same thing Mainly sell PCs, printers, and other computer peripherals o Next 2 are slightly different High touch, low velocity Ship to products directly to the data center o Servers Europe o Top 5 have 62% share o #2 and #4 in Germany have merged (# 1 market in Europe) Synnex is no longer a price spoiler No longer have to build share fast to achieve the scale they need to compete The CEO was the CEO at Ingram He is focused on return on tangible capital (ROTC) and profits now o Margins are trending up Lifting the weight off of the shoulders of the industry o This reduces pricing competition Focus on ROC in the entire industry Was previously focused on growth Didnt talk about ROC at all o Synnex is now talking about ROC o Same is true of Tech Data now Company wants to achieve a ROC 500bps above the cost of capital o Ingram has a chart dedicated to ROC now Targeting ROC 300-400bps above the cost of capital Each company is pursuing growth adjacencies with little overlap Better growth opportunities and better margins

Ben Claremon: The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

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Ingram o Data capture and point of salebar code scanners Synnex and Tech Data are not in this market o Logistics 3rd party logistics Have inventory but dont own itget a fee for service 50% of all items distributed from WalMart.com come from an Ingram warehouse o Apple and Amazon as well Tech Data o Mobility Synnex o Outsourcing Call centers The overlap between the 3 is in the data center market o Higher margin business o Really going after other firms markets o These 4 changes can drive mid-teens returns on capital give the changes in the industry Fears of the cloud o A major headwind to this business in general is customers moving to the cloud o Cloud computing- distribution of software applications over the internet Characteristics Shared servers rather than in-house servers o Servers are in 3rd party data centers Virtualization Cheaper and broader broadband pipes make the move easier o Big growth expected 35% CAGR through 2013 o 2 impacts on the 2 tier distribution Softwaresome companies will shift to the cloud Others will leverage two tier distribution Hardware With the server not on premises anymore, they will not need certain hardware There will absolutely be an impact if companies to go to the cloud and circumvent two tier distribution However, just like not all IT services got offshored to India o Not all software/hardware is going to be going to the cloud: Bandwidth constraints Mission critical apps Service disruptions Legal/compliance

Ben Claremon: The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

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Customized software o 68% of their sales will not be impacted by the cloud Peripheralsmonitors, printers PCs o At risk at to competition from the cloud is the remaining 32% Mainly software Worst case o 50% shift to the cloud n 5 years Very draconian downside scenario 16% of revenue could go away if half of the 32% exposed goes away Lose $1.1B in revenue But the other 68% of the business will still grow If it can still grow at historical growth levels, that would be $1.2B annually o Revenue would be about flat o Company is priced for an Armageddon scenario Base Case o 30% shift to the cloud in 5 years $3.3B headwind over 5 years Potential offsets Cloud is going to need 2 tier distribution as well o Value of 2 tier is not eliminated o Cloud-based service providers will need to be able to tap the SMB market They will not build out their sales forces There will be a land grab First to market will be important o The reseller will need 2 tier distribution Will aggregate a 1 stop suite for cloud customers o 50% of lost sales to the cloud could be offset Higher end data center productshigher margins POS bar codes and scanners Base case is 3% growth per year Upside case- 10% shift to the cloud (20% is his actual guess) o 5% growth projected by IDC for non-cloud IT spending None of the range of outcomes is horrible o 0-5% annual growth even if 50% goes to the cloud Valuation o Significant downside protection and 100% upside o During a 5 month period in 2008 and 2009 the company traded below tangible book value (TBV) Is credit exposure an issue? Write offs are 1% of gross profits over time Only a small uptick in 2008 and 2009

Ben Claremon: The Inoculated Investor

http://inoculatedinvestor.blogspot.com/

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Concerns were unfounded Is there inventory write down risk? 80-90% has contractual rights of returns or price protection o Very little inventory risk Gross margins actually improved during the downturn Profitable every quarter during the downturn $0 inventory write downs Managed the downturn really well Trading at .9x TBV Synnex (SNX): 1.5x TBV Tech Data (TECD): 1.3x TBV Base case 3% revenue growth, some reasonable SG&A leverage 8% EPS growth 13% return on invested capital (ROIC) o Apply a 12x forward multiple and add back cash they will use for a sizable buyback and some tuck-in valuations $35 price Upside is 90% o Thinks that ROIC will be better than before and the multiple could expand to 13-14x

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Risks o

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Severe downturn in global IT spending But the stock only trades at .9x TBV o Company is implementing an ERP system