Wednesday, April 16, 2014

I am in the New York Post

There is an article in the New York Post about me.

Here it is.



Thursday, April 10, 2014

Dissenting proxies

I have absolutely no idea of the issues involved at Harvard Illinois Bancorp - but they led to one of the funnier dissenting proxies I have ever seen.

I will save you the bother of reading. The introduction is as follows:

Dear Fellow Shareholder,

Below is a picture taken at last year’s annual shareholder meeting of our Bank’s Chairman.  None of the other board members bothered to wake him up.

Photo taken at annual meeting on May 23, 2013 at 2:54 pm.

If you, like me, believe it’s time to bring a fresh influence to our Bank’s board of directors, please vote the GREEN proxy card for Mark Saladin.



Tuesday, April 1, 2014

Charlotte: an old meeting with Bank of America

I finally got out of the hotel and walked around the street of Charlotte a little. Still sick, just less sick than this morning.

The sun was out. The weather was perfect. The blossom pink on the trees and everything so clean.


Last time I was here was I think in 2002 and it was a brief visit. I met with the investor relations departments of Duke Energy, First Union (!) and Bank of America. It was the BofA visit that defined the trip.

I spent half an hour trying to tease out what an ugly credit cycle looked like for them and in exasperation they gave up. They said (and you can probably work out the date by the numbers which seem so small now)...
We have 36 billion dollars in revenue. 18 billion in costs and 4 billion in credit costs. Surely it is more important to watch where the 36 and the 18 go than to focus on the 4. 
The world in Charlotte is so clean.


American Airlines vs Herbalife

I am sick in bed in a hotel in Charlotte.

Very sick. Fever.

I had a flight booked tomorrow from Miami to Boston - but there is not a chance in the world I can make that flight.

So I tried to cancel.

I logged in to American Airlines website. It didn't work.

It turns out that if you booked on an Australian website you need to log into the Australian website even when you are in America.

Logged into the Australian website and found my flight. Got up the ticket but there was no refund option.

So I googled American Airlines refunds. American Airlines has a separate website for refunds (I guess they are hoping that some people can't find it and they can deceive them out of a fare).

Alas I could not log in with my Australian booking number.

So I googled refunds, American Airlines Australia. There is a site and I could find my booking but there was no option to refund.

But they did link a phone number.

Got put through to a voice recognition phone centre that could not recognize me.

After about ten minutes I get an operator who can't do the refund - but they did eventually transfer me to an international operator who could do the refund. Slowly.

It was done.

I assure you that it is harder to get a refund from American Airlines than it is as a Herbalife distributor.

And the process is far more deceptive.

I am waiting until some hedge fund manager comes out with a billion dollar short on American Airlines. Meanwhile I am going to write to the Federal Trade Commission about American Airlines unfair behaviour.

Alas I will have to deal with this rather severe limitation on the FTC's power:

(n) Standard of proof; public policy considerations 
The Commission shall have no authority under this section or section 57a of this title to declare unlawful an act or practice on the grounds that such act or practice is unfair unless the act or practice causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers themselves and not outweighed by countervailing benefits to consumers or to competition. In determining whether an act or practice is unfair, the Commission may consider established public policies as evidence to be considered with all other evidence. Such public policy considerations may not serve as a primary basis for such determination.

You see the practice of American Airlines - which makes it ridiculously difficult to claim a refund which you are entitled to seems unfair. I guess if it is "reasonable" then the Commission has no power to declare it unlawful on the grounds that it is unfair.

The process at Herbalife is much easier. It is reasonably easy to get a full refund and the refund includes postage. The section above somewhat it seems limits the FTC's power in the Herbalife case.


Monday, March 24, 2014

Herbalife internal consumption: a comment

The debate on Herbalife has come back to the issue of internal consumption - that is how much of Herbalife's product is consumed by their own distribution network rather than external customers.

Peter Vander Nat - an economist for the FTC - has written a paper which gives Herbalife bears a lot of succour. He doesn't much like internal consumption. If Peter Vander Nat's paper is decisive then Herbalife will have a very tough time with regulators.

Dan McCrum - one of two consistently anti-Herbalife journalists - harps on about internal consumption as being the hallmark of a pyramid scheme. Here is yet another article.

And the most ardent Herbalife bull (and I am an ardent bull) must admit that a multi-level-marketing scheme where all the consumption is by people in the pyramid gives you pause. You have to ask where are the real customers? And if there are no real customers then surely it is a pyramid as a matter of fact (if not a matter of law). And pyramid schemes will eventually collapse on their own - they don't need the FTC to bring them down - even if government action speeds up the process. [And that is an important point - if the Ackman thesis on Herbalife is correct the government action doesn't change the end result - just the speed at which that result happens.]

But it is also clear that not all internal consumption is problematic. I have no problem with a young woman signing up as an Avon lady so she can buy cosmetics at a discount. I am sure plenty do. And if she takes half an hour putting on make-up in preparation for Saturday night - isn't that real consumption?

And I have spoken to several Herbalife customers and they are mostly signed up as distributors and they do not intend to sell product. They are signed up simply to get the 25 percent discount. Some even bulk up their orders between a few of them to get 35 percent discounts - but they still intend on making no retail sales except to themselves as a "buying club". Indeed when I went to the Herbalife in Queens I spoke to several people who were real customers and were proud of the weight that they had lost being repeat customers over many months. They were buying Herbalife at full freight from one distributor (the owner of the nutrition shop) and were themselves Herbalife distributors to buy product at a discount at home. These people never sold Herbalife except maybe a little to family members. But they still purchased Herbalife independent of their own distribution arrangement and clearly and publicly consumed it.

I should (overriding my bullishness) explore this - a crux issue in the Herbalife debate neutrally. I expect bears to comment - and I figure this will wind up being more than one post. So lets give an example of clearly bad internal-consumption and an example of clearly-good internal consumption. I am not saying whether either of these examples predominate or even exist within the Herbalife network - but just outlining what might be a very bad position for Herbalife or a very good position for Herbalife.

Whether the examples exist or predominate is a fact to be checked on the ground - not a theory to be hypothesized. The FTC I hope will check the facts on the ground rather than pontificate on theory.

But then I suspect the FTC will be better than many a Wall-Streeter. There are many people who have an opinion on Herbalife without doing their own research - and instead they borrow "facts" from convenient parties. Bill Ackman claims to have done a lot of research. I have done a fair bit and wound up at a diametrically opposed position. I don't expect you to take either of our claims seriously without doing your own research. We both have vested interests.

This post doesn't do the research for you. It outlines a process by which you can do it for yourself. There is very big money to be made here - Herbalife in the conception of the bears goes to zero. I think it goes well over $100 and probably eventually closer to $200.

This is a place where if you do the research you can know - and you can make a lot of money. But you also need to worry about the FTC deciding arbitrarily and - like much of Wall Street - not doing the research. [And that is a worry you need to have whether you are a bull or a bear. Arbitrary government decisions happen and they are not pretty.]

Anyway lets start with two examples:

Example A: Clearly bad internal consumption

If you are a Herbalife "Senior Consultant" you can get a 42% discount on your product if you place a single order of 1000 volume points. That 42% discount applies that month only. This is described in this video from a couple of very senior Herbalife distributors (the critical bit starts at 5:20):

This clearly encourages people to place one order - a "success builder order". And it is a pretty big order. A pack of Herbalife Formula 1 - the key diet shake product - is about 24 volume points - so the order would need to be over 40 packs of Formula 1 - each pack being 750 grams. With discounts the order is still around a $1000.

Now you could imagine a situation where an unscrupulous upstream distributor encourages someone to place such an order - explaining to them that this large order will make their margins 7 percent better (42 percent discount rather than 35 percent) and that 7 percent means that when they sell it to the throngs of waiting customers they will make more money.

And you could of course imagine that our hapless victim doesn't find the throngs of waiting customers - and is left with something like 30 kg of unsold (and in my opinion unpalatable) protein shakes and doesn't want to throw them out and so internally (ie self) consumes.

A "meal replacement" is roughly 60 grams - so our poor person either throws out their shakes, stores it indefinitely, starts selling it on EBAY or Craigs List in distress, or starts drinking very regular meal-replacement shakes. 30kg is 500 meals so they could self-consume this quite reasonably in two years.

But they may feel victimized. This would be bad internal consumption - inventory loading based on fraudulent business opportunities.

There are several defences to say this does not exist. Herbalife has a refund program for unopened Herbalife product sold to distributors - and the refund option lasts a full year. The refund does not include postage (so our victim will be out of pocket). Moreover the victim may not be aware they are entitled to a refund - and their upline will actively discourage them taking a refund as the upline will docked volume points. Moreover I have seen companies that overcharge for postage (postage as a profit center), and I have seen companies where it is almost impossible to cancel a contract or get a refund even if you are legally entitled. I have also seen companies where it is impossible to find details on the refund even when it clearly exists. So the facts of the refund need to be tested on the ground.

Whether these people exist or even predominate in the network is - of course - determined by facts on the ground. This post does not check the facts on the ground. It is thinking about things rather than actually doing those things.

Example B: Clearly acceptable internal-consumption

Very early in my Herbalife travels I met a Hispanic guy in a Herbalife club. He had been a customer for about twenty months. He had lost about 50 pounds and he would say to you with sincerity that Herbalife saved his life. He was signed up as a distributor.

He was sitting in a Herbalife club drinking a shake which he paid $5 for. This was the same price I paid for it - that is retail. This was real consumption - and he was not in the Herbalife club to participate in a scheme - rather he was there to chat with his friends and drink protein shakes.

My distributor had a job - and he had no intention of making a living selling Herbalife. His photo was on the wall of the Herbalife club as a success story - with gold-stars next to his name as he met weight targets.

Most breakfasts he came to this club on the way to work. He did it to chat with friends and the proprietor (who had become a friend if he wasn't a friend already). He was however a distributor as well - originally so he could buy the product for home consumption at a 25 percent discount though he had (being a true-believer in the product) sold some to product to friends and relatives. However that is incidental. Almost all the product he purchased he consumed himself.

But he is also clearly a real consumer - and he had come to the store maybe 200 times to consume and each time he had paid the same price a retail customer pays. His cumulative payments were over $1000. Over time I would expect him to spend a fair bit more than that.

This is technically self-consumption. This is product sold to an internal distributor - but it is very difficult indeed to argue it is problematic and Peter Vander Nat's assertions about the wrongs of self-consumption are clearly off the mark in this case.

The fact that this is an "internal sale" doesn't make the consumption any less real.

It has a characteristic that is important though - it is repeat business. Anywhere you see repeat business it is very hard to argue the customer is a victim. People get ripped off regularly - but they seldom go back to the same source to get ripped off again.

Perhaps the right question to ask is not the David Einhorn question of how much of the sales are to customers outside the base but how much of the sales are to repeat customers - and how often do they repeat. Repeat purchases by individuals are not consistent with inventory loading fraud even if the repeat purchases are internally consumed.

If the sales are to repeat customers then almost all of Bill Ackman's arguments fall apart.


Checking the facts on the ground

I know some people out there plan on actually doing due diligence. Here is a plan...

You could go and find a bunch of Herbalife distributors. Its not hard to do.

Get out an Android phone in any Hispanic-rich area. Ask it to navigate you to Herbalife distributors and start asking questions when you find them or do not find them. I did this starting at Avondale Arizona and took this screenshot. A similar screenshot in Corona New York is laced with Herbalife distributors.

If two days of legwork throws up a lot of people who may be internal consumption (they are signed up as distributors but drink the product) but that most of that internal consumption looks like my bad example then short the stock and send your detailed evidence to the FTC. [Send it to me too... I like knowing when I am wrong.]

If however the internal consumption looks like good internal consumption (repeat customers mostly) then Bill Ackman is wrong and it should be easy enough to convince the FTC that this is a real business and Ackman should be ignored.

I have met several customers who are true believers. They really believe Herbalife saved their life and it is a wonderful product - and they are mostly right. The cult-of-weight-loss shakes works for them. Herbalife has saved their life.

Herbalife's best defence is to get testimonies from more than 100 of them and send those testimonies to the FTC - or better get their customers to send the testimonies to the FTC. Before and after photos are good. If they get 1000 plus of these they win. After all 1000 plus people who have been in the meal-replacement game long enough to lose 50 pounds is good evidence of intended, deliberate personal consumption - and it shouldn't matter a jot whether the people are signed up as distributors. [Someone who actually loses 50 pounds is a real customer of a weight loss club no matter whether they work there or not...]

Short circuit this process:

There is a simple way of short-circuiting this process. You can for a few hundred dollars and some pain work out whether Herbalife is a pyramid scheme. Herbalife will hate me for saying this because it imposes costs on them.

The solution: sign up as a Herbalife distributor. Place a success builder order. See if all the information needed to get a refund is available easily available.

Try and get your refund.

If it is easy to get and they do not gouge you on postage then it simply cannot be an inventory loading scheme as-per-Ackman. For this to be a pyramid scheme you have to have literally millions of distributors stuck with unwanted inventory.

If the company offers and honours refunds to failed distributors then the idea that the whole scheme works by selling inventory to failed distributors is ludicrous.

If you do this take your position in the stock, send your information to the SEC and wait to profit.

Oh, and send it to me too. Always interested.

One for the observant

People who read my posts obsessively (and there are a few of you) may notice that in the screenshot above there is a Herbalife distributor in Botany Street Bondi Junction. Bondi Junction is not in Arizona, it is in Australia and it is where Bronte Capital has its offices. Its in there because I marked it in my personal Google maps.

The Herbalife distributor in that screenshot is United Online Business Systems - which isn't any old Herbalife distributor. It is the Australian arm of Shawn Dahl's distribution business. Shawn Dahl is the most infamous scummy Herbalife distributor - the one that sold leads and false business plans and is the centerpiece of most of Bill Ackman's examples. There is a very good story in the Verge about Shawn Dahl's business and Shawn Dahl was the first distributor Bill Ackman outlined when he started writing up the business of distributors.

It is kind of ironic that the iconic scummy Herbalife distributor is the closest Herbalife distributor to my office.

Shawn Dahl is no longer a Herbalife distributor. Herbalife kicked him out of their network. I could find no trace of his Australian office. [Fair point to Bill Ackman though: it took Bill Ackman before Herbalife got rid of Shawn Dahl. They should not have waited that long.]

Criticism where criticism is due

I don't normally criticize the press - but here I am getting a touch annoyed. The FT have written dozens of stories on Herbalife. The FT has journalists in dozens of countries. I am critical of Wall Street (myself included) for thinking about things but not actually doing those things. [I have spent a lifetime thinking about things without actually doing those things.]

I am double-critical of news organizations who report without leaving their desk and without checking the facts on the ground. But who - like me - are very good at theorizing.

The FT is uniquely placed to bring some rationality to this debate. One day they could send a journalist to a distributor in six or seven different jurisdictions. May I suggest (a) Corona New York, (b) Los Angeles, (c) Mexico City, (d) Kuala Lumpur, (e) anywhere in China, (f) Australia. KL is probably Herbalife's strongest market - so that is an important inclusion.

After doing this the FT will be able to answer definitively whether there are large numbers of real customers globally and those customers voluntarily consume the shakes because they want to consume the shakes, or whether the customers are just suckered distributors as per Bill Ackman.

It is however work - probably a day work for six journalists. But it is a great story - and real facts are the reason you buy the financial press.

I have done this mostly myself. However nobody will believe me because I have a financial interest in the results. Its time for the press to reassert itself as a conflict free arbiter of real data. For that I will gladly pay the several hundred dollars a year for the FT's strangely coloured pages.


PS. Dan McCrum - who seems to write most of the FTs stories on Herbalife - lives in London. London is strangely devoid of Herbalife clubs. I tried to find one to visit with Dan in London and flat-out could not. Herbalife in the UK ranks very low on Google Trends - and My Herbalife - which is the search you would do for the Herbalife distributor portal - barely ranks at all. Dan's location makes it very hard for him to do the checking on the ground his stories warrant. If there is criticism of Dan's work ethic it isn't meant. It is criticism only of location.

Wednesday, March 5, 2014

Letting Qantas go bankrupt would be good for Australia

[For non-Austrlaians: Qantas is a former Government owned airline in Australia - and still seemingly our "national carrier". Its parlous financial position is a political issue in Australia this week.]

When I was in my twenties I worked for the Government of Australia and I watched the privatisation of Qantas fairly closely.

In those days the Finance Department swallowed the Qantas lobbying totally. What was good for Qantas was good for Australia.

In all seriousness bureaucrats who should have Australia's interest at heart were all for restricting competition on the Kangaroo route [Sydney-London] to keep Qantas's profits sweet. After all more profits meant a higher sales price.

Tourism those days was a huge industry - driven in part by the then low Australian dollar. Londoners came over by the plane load and tourism operators up and down the coast of Queensland were making hay.

What Qantas was arguing for was restricting their customer numbers.

If the average middle-income coastal town knew about and understood the issues they would have rioted. But Qantas obscured their self-interested bile by wrapping themselves in the Australian flag.

Little has changed except now the issue is the solvency of Qantas, not the sale price. Qantas has been so mismanaged it is almost the only airline in the world in financial trouble now. The rise in Chinese demand (including Chinese demand on say Shanghai-Sydney flights) has meant that fuel efficient aircraft are in short supply and any airline who has managed their fleet well is making excess profits. [Just look at the stock charts for US airlines.]

Qantas however has mismanaged its fleet to a degree that is now ludicrous. This week I will by flying Sydney to LA on a 777 - a two-engine jet. Qantas does the route on old 747s (four engine jets). These are tens of tonnes of fuel less efficient and Qantas is higher cost because of fleet mismanagement as much as anything else.

But the fleet mismanagement goes further. Decades of incompetence has left them with the most amazingly heterogeneous fleet in the world. This airline deserves to go bust.

But like the Qantas of old it goes to government who seem to think for some ungodly reason that the business is even important.

There will be other airlines after Qantas. They will be cheaper, have better service and use more fuel efficient planes.

And they won't believe that what is good for them is good for Australia.

It is time to let Qantas fail.


And just for the record: we are not short Qantas. But two decades later I retain my anger about their false patriotism.

Tuesday, February 25, 2014

Mt Gox, bitcoin, Hordes of Chaos, Demons and armies of Orcs...

One from the vaults.

In April last year I posted on the origins of Mt Gox - the bitcoin exchange.

To celebrate the collapse of Mt Gox I have decided to reprint the post:

--- is the main exchange for bitcoin. I am not inherently opposed to bitcoin as a small and interesting speculation (though I would not do it for my clients). I think bitcoin probably goes to zero - but only probably...

If you want to understand bitcoin the best explanation I have found is on the self-evident blog...

However it is the history of MtGox - that amuses me...

MtGox started as an exchange for trading cards in a fantasy role playing game. It stands for Magic The Gathering Online Exchange.

But between trading playing cards and trading encrypted tokens certified with a file-shared registry it distributed an online game called "The Far Wilds". preserves some of the website:

The Far Wilds is a unique turn based strategy game. Configure an army and fight on a random battlefield. 
Battles are dynamic. You must adapt your strategy to different battlefields conditions and opponents.... 
The Celestial Imperium moves out toward the northern wastes to respond to the rising tide of the Hordes of Chaos. Disciplined and Powerful Psions wield their minds against twisted Mutants. Priests and Paladins of Xosa battle with Demons and armies of Orcs across the wilderness of the Borderlands.


Monday, February 24, 2014

The really strange Comcast-Netflix deal

Advanced warning: the first comment here linked to an article which clearly understood this better than me. I am still perplexed - but this post should be taken with a grain of salt.



Verizon took the FCC to court on net neutrality and won.

The big potential loser was Netflix. Under the old rules [the ones that the court overruled] tier one internet providers like Comcast or Verizon had to deliver Netflix packets the same way as they delivered any other packets (on landlines anyway) - and that meant that they could not selectively slow Netflix packets. If they were not allowed to selectively slow Netflix packets then they couldn't charge Netflix for the privilege of having their information delivered.

The argument for slowing them is that Netflix uses so much - and - so say Verizon and others - they should "pay their share". [Of course the counter argument is that when I buy my capacity I am paying for data to be delivered to me - and I have paid for all data, not all data except Netflix...]

Winning the court case had to be a positive for Verizon (that is why they took it to court). And it had to be a negative for Netflix (the most likely party to be charged). You wouldn't notice that in the stocks though - Netflix is up hard, Verizon not so much.

Comcast had more reason to dislike Netflix than Verizon though. After all Netflix competes with Comcast's core service (video delivery) and Reed Hastings of Netflix used to complain endlessly about Comcast's breach of net neutrality rules.

However Comcast - as part of its deal in purchasing NBC - agreed to follow net neutrality rules until at least January 2018 even if the FCC lost the net neutrality issue in court. After the FCC lost in court there was only one company that could not legally selectively slow Netflix content - there was thus only one party which Netflix did not have to deal with.

That party was Comcast.

And so it is really strange that the first deal Netflix did was with Comcast.

Netflix has just given Comcast a few million dollars - and seemingly for no reason.

Now Reed Hastings is a clever man - and he is not in the business of giving away millions of dollars.

So I presume he did it for a reason.

And I think it is this. The reason is to set a price. A low price. The lower the better - because after this they have the serious negotiation with Verizon. [And Verizon took the government to court and won - which leads you to think that Verizon is likely to be aggressive.]

Comcast knew they were not entitled to a brass razoo - and Netflix was giving them a few million dollars. From Comcast's perspective that was easy [take the gift]. The amount looks low. Comcast manages to look reasonable (and I don't normally put the words reasonable and Comcast in the same sentence).

And Netflix sets a low price.

It's a negotiating ploy.

But I don't believe it will work.

Lowell McAdam is unlikely to fall for it. He is not going to settle for single-digit millions. The tables have turned and the carriers are getting market power over Silicon Valley - and this is probably the quickest and easiest place to exert some power.

I think Reed Hasting wasted his few million.

Seeking different opinions as I have been wrong often.


No position in Comcast, Netflix. Long Verizon.


Friday, February 21, 2014

I am out of tune with these times

At core I am an old-fashioned value investor. Maybe a growth-orientated one - but the valuation has to make sense on fairly modest assumptions before I get excited.

I owned Facebook in the twenties. I could make the per-subscriber numbers work - and it was a mid-single digit times revenue and it seemed a fairly good bet that revenue would rise a lot and that margins on that revenue would be good. I am not averse to paying six times sales for businesses that are growing fast if the end-margins are likely to be good.

At the time the (incorrect) consensus was that Facebook would not manage the transition to mobile.

I sold my Facebook holding as it went up. Too early I regret - and at least in part unintentionally. I purchased the holding by writing put options perfectly happy to have the stock put to me. I sold by writing call options, modestly happy if it was called. I just had a buy-price and sell price in my head based on what I thought were sensible valuations and decided to pocket a little premium around them. [This is almost the only stock Bronte has ever acquired this way. We did it because the option premium was extraordinarily high and we figured the business was far less volatile than the stock.]

These days I am no longer so in tune with valuation.

Yesterday Facebook did an acquisition that makes no sense to me. I had previously - on Twitter - questioned the $900 million paid by Rakuten (in Japan) for Viber. But that price looks modest compared to the price paid for the (much better) WhatsApp. 

Obviously this makes sense to somebody - and indeed to people who are far cleverer than me. I don't want to second-guess Mark Zuckerberg who has done things and built things and added more value in a week than I might in a lifetime. 

But I would have laid a large bet that Facebook stock would finish down after that acquisition rather than up and I would have been wrong.

used to be an unremitting bull on the market (a position that is deeply uncomfortable for someone whose skills and inclination are on the short side). I am not bullish now - and have positioned far closer to neutral than any time in Bronte's history.

But I am not comfortable with that position either. Clever people are doing things I don't understand and I am just feeling old and tired. 


PS. No position on $FB. Still long $GOOG. 

Monday, February 10, 2014

Blue Nile and Marc Andreesen's theory of public company shareholders, oh and a valuation of Amazon

Marc Andreesen (@pmarca for the must-follow twitter account) has been toying with a theory of public company shareholder. The short (Twitter) version is "At any given time, public co's shareholder base consists entirely of one of: growth investors, value investors, arbitrageurs, or nobody." This has been refined through tweets.

The growth investors will hold a stock as long as the rate of revenue growth does not slow. When it slows they dump - and the shares of really fine companies can fall sharply because the growth rate falls from (say) high single digit to mid single digit. What are objectively great results can see 25 percent price falls simply because the results do not measure up to the expectations of the shareholder base.

The growth investors don't much care about earnings (they come later). But they do care how big the eventual market becomes.

A recent example of a fall (which may or may not be justified) is Amazon who were seen missing lofty expectations for Christmas sales. [The sales numbers were fantastic, just the expectations were more fantastic.]

A fallen growth stock doesn't become fashionable again until it has a lower-than-market price-earnings ratio where it attracts "value investors".  Value investors have a different agenda. They want the business run for cash and maybe for buybacks. Shareholders will pressure management to meet their expectations. [Example: Apple.] If earnings fall or buy-backs slow these shareholders are disappointed.

Below the value investors - and mentioned in later tweets - are the Ben Graham style bottom feeders who get really interested when the stock is trading at half cash. Whereas traditional value investors want the business run for cash the true bottom feeders want the business closed for cash. Zynga at bottom was borderline of interest these investors.

Outside this are the arbitrageurs that just want to rent the stock for a short term deal. No deal and they are disappointed.

This is a generalization. But being a non-conformist at heart I want to look at the places between - stocks dumped by growth investors for example before they become interesting to value investors - or stocks that are approaching Ben Graham levels but still have viable businesses.

Between the cracks are interesting places to look. Zynga was interesting at the edge of being a Ben Graham stock. Google's had a slowdown that lasted one quarter. Buying a growth stock when the slowdown is temporary and lasts one quarter provides great opportunities. See January 2012 where Google dropped a double-digit percentage in a sharply rising market.*

So I am going to look at a twixt-and-between stock: Blue Nile. This is a failed growth stock that doesn't yet have a low PE and has an enormous short interest. The company recently missed and guided revenue and earnings down - which is problematic for a stock with a 50 PE ratio.

The knock on the stock: it has been missing expectations for years.


The Jeweller with one of the all-time-great business models

Blue Nile has possibly the most seductive business model I have ever seen. It is an online build-your-own seller of engagement rings.

The modal purchaser of an engagement ring is a man in their 20s or the 30s who doesn't give two hoots about jewellery. The purchase is large (a month's salary?) and is full of terms that he doesn't know (VS2 clarity anyone). He is buying it for someone who he hopes will accept his proposal.

The ideal customer provides no return business. Ever.

The total absence of return business means that the downside for ripping customers off is low. [They are not coming back so if you gouge them it won't matter.] The high-ticket price and the general ignorance of the customer guarantees a rip-off. If the customer is at all sophisticated about human nature they know it.

The shop-keepers know this too. They have glamorous premises (which just adds to the feeling of being ripped off). They use lighting tricks to make the diamonds sparkle. And the sales guys are - in my one-off experience** - a less explicitly testosterone laden version of car salesmen. Slick. Dishonourable. But smooth, so smooth.

Into this comes Blue Nile who offer diamond engagement rings on a build-your-own basis with transparent pricing. You go to their site and choose one stone, three stone, this clasp, that clasp, this quality and size of diamond etc. They tell you if you are choosing a quality of diamond so high you can't tell the imperfections except with a microscope. As you move the slider up choosing a bigger diamond or a higher quality diamond the price changes and you can see the price change so you know how much you are paying for size/quality and settings.

The margin is thin - so there is no way you can feel "ripped off" and it comes in a blue-box which to my (admittedly unsophisticated eye) is just a darker, richer shade of blue vis the expensive boxes sold by Tiffany's.

If you have not played with the jewellery site do so. This is internet shopping at its finest.

It is also a truly great business model. Transparent pricing makes a guy keen to shop there. But the real joy is the negative working capital.

A traditional jeweller sits huge amounts of inventory around waiting for a victim (ahem: customer) to come through the door. They need to sell at a price high enough to get a return on all that inventory. Zale Corporation has $900 million in inventory. That inventory is the majority of their assets and represents about a year of cost of goods sold. The first 10% of margin is just getting a return of 10% on the inventory holding. Tiffany is even worse with $2.4 billion in inventory and annual cost of goods sold of $1.7 billion. They have 17 months inventory sitting around glistening under expensive lights and more expensive security. Margins need to be enormous just to give a return on inventory holdings.

By contrast Blue Nile recognizes diamonds are commodities and doesn't bother with all that inventory. They just buy-to-order. If you want a round-cut three-quarter carrot diamond with an ideal-grade cut and VS2 clarity it will cost you about two and a half grand and one is pretty well like another. So Blue Nile take your money, build the ring to order and ship it to you. Turn-around is not fast but is adequate and Blue Nile operate with negative working capital. At the last (and disappointing) numbers Blue Nile has $34 million of inventory (mostly non-engage ring product) and $134 million in accounts payable. The offset is a cash balance well over $100 million.

And Blue Nile can sell much cheaper than a traditional jeweller. A traditional jeweller with this turnover would carry maybe $350 million more inventory and would require a return on that. They would also need security and insurance for that inventory and would pass that onto customers. On top of that there are no premises and slick dishonourable sales people to pay. All this would add up to more than 20 percent cost advantage.

The advantage that Blue Nile has over its competitors is much bigger than the advantage that (say) Amazon has over Best Buy.

If you had that advantage the rational thing to do is to price really keenly, be as honest and transparent as possible and grow and grow and grow some more.

In other words to do what Amazon does.

One day - sometime in the dim-distant future - growth will slow because you have captured the market and then you price with say a 8% margin and mint money.

The maths will look like this. We don't know what the "end-sustainable sales" are but for every dollar of sales there is 8c of margin. Post tax there will be about 5.6 cents of earnings. Put that on 13 times and the stock will settle out at 72 percent of sales.

If end sales are a billion the market cap will be $720 million. If they are 5 billion the market cap will be $3.6 billion.

This maths gives you the quick way of valuing Amazon. Amazon sales are currently $75 billion. If they quadruple between now and maturation the end sales will be $300 billion. The end market cap will be $210 billion. The current market cap is $165 billion. If Amazon can quadruple sales the stock will be a winner. I think it probably will. But to do really well on the stock sales probably need to rise 600 percent. [We have no position in the stock.]

Alas Blue Nile is not Amazon. Despite what looks like a massive advantage and a near perfect business model Blue Nile just has not grown that fast.

In 2008 Amazon sales were $20 billion. They are now $75 billion. Sales have better-than tripled.

By contrast Nile has disappointed. Sales are only up about 50 percent. And in that time margins have slid so earnings are flat. Earnings are flat at Amazon too but nobody gives a toss. All they care about is the sales growth.

But they do give a toss at Blue Nile. Blue Nile guided for earnings/margins and missed. And their sales growth has slid to low-teens. It raises the question: if they really have a better business model why isn't it growing at the torrid pace that Amazon is growing.

One problem is that marriage just isn't that fashionable. Marriage rates are in historic decline... also people are stinging on engagement rings... but that doesn't quite explain it. Blue Nile remains way too small a part of the market.

The obvious suggestion is that engagement rings are such an emotional purchase that the bride-to-be really wants to see it and hence shops traditionally. And despite the movies men don't often get down on a bended knee and offer a surprise proposal ring-in-box proffered up ready for rejection. [I would have been way too insecure...]

And so the end market for Blue Nile is just not that big.


But there are offsets. Blue Nile does have a reputation for not ripping you off. I can imagine plenty of Chinese want loose diamonds as a form of portable wealth. The end-market here could be enormous. If Blue Nile can capture any of that the sales will be huge albeit at low margins.

And there are some technologies out there which will make Blue Nile a very much better business. The Oculus Rift is one of the hottest venture capital concepts. Cheap highly realistic 3-D virtual reality headsets are coming. 3-D scanners will also be under $100***. When you inspect real-estate online you will be able to walk in your headset through the house in realistic, high-resolution 3-D. When you buy jewellery online you will be able to see how it looks on your (or your bride's) hand. And you will be able to tweak it so you know when that stone really is so large it is grotesque. In other words online shopping will be a much better experience.


The value proposition in Blue Nile stock

Trailing sales are $450 million. The market cap is $442 million. Sales are growing still but the rate is disappointing. The PE ratio is over 40 but that is because the business is not earning much margin.

It is not a value stock yet. The PE is way too high.

Rather the stock is held by disappointed growth investors. After all this was the perfect business and it didn't perform.

Also it is closer to 1.0 times sales than my magical-end point of 0.7 times sales. It will get to 0.7 times sales one day - either by the price declining further or the sales increasing. Given the low-teens growth rate getting there via growth seems likely to me albeit at a slow-grind for shareholders.

In other words Blue Nile is twixt-and-between. Its not a great growth stock and is hardly a value stock.

It wouldn't be much interest to me except that it has a short interest of 20 percent of the float, is more than 115 percent owned by institutions and is - on the metrics above only about 20 percent overpriced. After all it will wind up as a value stock one day at 0.7 times sales.

We are in a market where lots and lots of stuff is more than 20 percent overpriced. So I don't get it. Can someone please explain the short interest? Do the shorts really believe this deserves to trade at half sales?


Why we own it?

When stocks have a very high short interest and the shorts are wrong the stocks are unbelievably large winners. Think Tesla, Netflix and - dare I say it Herbalife.

So far on Blue Nile the shorts have not been wrong. This is a company which is disappointing on growth and disappointing on margins. But as I noted there are things that can go right.

Top of my list is the Chinese developing a fascination with loose diamonds. The amounts of money here are enormous - and as a general rule I don't want to be short Chinese corruption. Chinese corruption is a very big market.

Maybe more certain: the Silicon Valley guys are completely obsessed about the Oculus Rift and immersive and cheap 3-D experiences. They are early (which is their job). Still I don't want to be short a real 3-D stock. Cheap 3-D technology will change the online shopping experience dramatically. I can see Blue Nile sales eventually quadrupling - in which case the stock is very cheap indeed. But that eventual sales growth relies on technologies that will not be widespread this year and are not part of Blue Nile's publicly stated plans.


*I remember well. We were long. January 2012 was our worst ever month.

** I am married to my first wife. Shopping for an engagement ring really was and will remain a one-off experience.

***Lidars with the processing power in your phone and the cloud.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.