Street Capitalist: Event Driven Value Investments

Vertical integration appears to be a continuing trend in the business world, with Coca-Cola’s (NYSE:KO) decision to acquire Coca-Cola Enterprises (NYSE:CCE) being the latest example:

Coca-Cola Co. agreed Thursday to buy the bulk of its largest bottler in a deal valued at about $12.17 billion, including debt, to gain more control of manufacturing and distribution.

Under the terms of the deal, Coke would give up its 34% stake in Coca-Cola Enterprises Inc., worth $3.4 billion, and assume $8.88 billion in debt, and all North American assets and liabilities. CCE agreed in principle to buy Coca-Cola’s bottling operations in Norway and Sweden for $822 million, and acquire a 83% equity stake in its German bottling operations in the near future.

CCE’s shares surged 30% to $25 in premarket trading, while Coca-Cola fell 2.6% to $53.65.

With the transaction, Coca-Cola Chairman and Chief Executive Muhtar Kent said the company was converting “passive capital into active capital.” He added it would give Coca-Cola direct control over its investment in North America to accelerate growth.

CCE shareholders will get one share of a new Coca-Cola Enterprises company focused only on European bottling and will get a one-time $10-a-share payment. The company plans to issue debt to finance this payment and the European acquisition.

Coke will control about 90% of the bottling of its products in North America. It expects cost savings of $350 million over four years and that the acquisition will add to earnings per share by 2012. The transactions are expected to close in the fourth quarter.

Coca-Cola Strikes Deal With Bottler (WSJ)

Dana Cimilluca, Betsy McKay, and Jeffrey McCracken go on to note how this is a big reversal in strategy by Coke. We saw the first example of this earlier with Pepsi:

PepsiCo announced last April that it aimed to subsume Pepsi Bottling Group Inc. and PepsiAmericas Inc. Pepsi said the $7.8 billion deal will allow it to have greater control over development, distribution and marketing of new products with the acquisitions, which are expected to close Friday.

Owning its bottlers allows PepsiCo to negotiate alone with retailers, rather than sharing that task with representatives of separately publicly traded bottlers…

When PepsiCo Chairman and CEO Indra Nooyi launched that company’s similar move in April, she said owning the two bottlers would give it the flexibility to decide how its beverages should be distributed. As the industry moves from a heavy reliance on carbonated soft drinks into water, juice, teas and other noncarbonated drinks, some soft-drink bottlers don’t have the equipment to manufacture the noncarbonated drinks and many are sold in small volumes. “We can accelerate revenue growth and be more agile and flexible,” Ms. Nooyi said at the time.

PepsiCo has said it expects to save $400 million by 2012 from the deals. But Bill Pecoriello, chief executive of ConsumerEdge Research LLC, believes the company may actually reap more than $600 million.

These deals make sense for Pepsi and Coke as consumers shift away from soft drinks. With consumers becoming more health conscious, they are looking towards healthier drink options, think Vitamin Water or juices and teas. This is problematic for Pepsi and Coke because they didn’t have the power to bring such drinks to market. By shedding their bottling units in the 80’s, they were able to take assets off of their balance sheet and become more akin to marketing companies — thus boosting their ROIC. Now though, even if they generate good returns on invested cash, they still face the problem of lagging behind upstart competitors. Coke needs control over bottlers so they can push new investments in equipment and strategy, to bring non-carbonated beverages to market. The price of that lag can be staggering, Coke’s decision to acquire Vitamin Water for $4.1B is evidence of that.

The main problem stems from the fact that the bottling business is expensive and very capital intensive making it difficult to quickly deploy resources in trying new and untested beverage concepts. I would guess that Coca-Cola Enterprises is reluctant to do this, given the nature of their business, and would rather have Coke shoulder the risk. How does that shouldering of the risk occur? Coke sells Coca-Cola Enterprises its syrup at a certain price. Longer term fixed prices for syrups would have enabled the bottlers to raise prices and increase margins on their end, without having to resort to increasing the volume of their sales. But, it seems as if such an agreement was not possible, and Coke had to follow Pepsi’s lead in a bottler acquisition.

Still, there is some savvy dealmaking behind the transaction. Unlike Kraft’s decision to sell its Pizza business to Nestle in a poorly structured manner that incurred a high tax rate, this deal looks as if it may be a tax fee exchange in which their equity position in the bottler is swapped for operating assets. However, deal will undoubtedly dilute Coke’s return on invested capital. Coke’s ROIC appears to be at about 22% whereas the bottling unit CCE achieves a low 7%. But, this may make strategic sense in the longer term as Coke and Pepsi fight to expand beyond their carbonated offerings and continue their dominance as

Overall, this looks to be the continuation of an ongoing trend where companies are integrating vertically as their margins are pressured by shifts in the market and consumer demand. I loved Ben Worthen, Cari Tuna, and Justin Scheck’s piece in the Wall Street Journal on it:

…executives [are] reviving “vertical integration,” a 100-year-old strategy in which a company controls materials, manufacturing and distribution. Others moving recently in this direction include ArcelorMittal, PepsiCo Inc., General Motors Co. and Boeing Co.

The reasons vary. Arcelor, the world’s largest steelmaker, wants more control over its raw materials. Pepsi wants more authority over distribution. GM and Boeing are moving by necessity, to assure quantity and quality of vital parts from troubled suppliers. Some are repurchasing businesses they only recently shed.

“The pendulum has shifted from disintegration to integration,” says Harold Sirkin, global head of the Boston Consulting Group’s operations practice. He attributes the change to volatile commodity prices, financial pressures at suppliers and quests for new revenue — challenges exacerbated by the recession…

Such steps don’t necessarily portend a return to the early-20th-century vertical conglomerates of Andrew Carnegie and Henry Ford. Then, Carnegie Steel Co. and Ford Motor Co. each owned iron-ore mines, while controlling everything from manufacturing to sales.

“The historical view of vertical integration was that you had complete control of the supply chain and that you could manage it the best,” says Bain & Co. consultant Mark Gottfredson.

Today’s approach is more nuanced. Companies are buying key parts of their supply chains, but most don’t want end-to-end control.

Companies More Prone to Go ‘Vertical’ (WSJ)

If the trend continues, investors could go hunting for some of these key supply chain players that are publicly traded. If they are undervalued, an acquisition would undoubtedly be a catalyst for that value being unlocked. For investors in the acquirers, you can expect some of that ROIC being sacrificed.

I’ve always thought that investing in Apple (NASDAQ:AAPL) would be a terrifying experience. The company’s 20X P/E ratio and fierce scrutinization by Wall St. analysts makes it so that they must constantly iterate and come out with new devices to meet earnings expectations.

When you have an iPhone and an Apple computer, what else do you really need from Apple? That is where the iPad comes in. By using the iPhone OS, Apple is able to dig a moat around the device’s software. To develop rich applications for the iPad you are going to have to sell through Apple’s app store. And every application sold gives Apple a 30% cut. To be fair, this is not entirely new ground here — the iPhone came out with the app store first, but now we are seeing Apple’s attempt at using this same approach to software for general computing.

Look at Apple’s current revenue streams:

About 83% of revenues are coming from what I would characterize as hardware sales. If Apple can grow their App Store, they have the potential of getting a new revenue stream that is actually much more attractive than their hardware business. Creating a distribution channel for applications, where Apple simply takes a 30% cut, makes a new business line that requires little actual capital to operate. The returns on invested capital are huge and they have the potential to offset the need for constantly innovating on the hardware side of things. Instead, Apple could position itself to start receiving a healthy income stream from consumers on an annual basis.

The potential here is great. With his announcement yesterday, Steve Jobs positioned the iPad as a media consumption device. He wants you to use the iPad to browse the internet, watch TV/Movies, and read books. For content providers, Apple’s control over the user experience is a big deal. You don’t have to worry anymore about ad blockers and you might actually be able to create some truly creative advertising experiences by leveraging the device’s abilities.

For publishers, the iPad is no silver bullet. What you might see though are publishers who step up to the plate to make applications worth paying for. For most local newspapers that are bleeding to death, this scenario is unlikely. For larger publications, like the New York Times or Wall Street Journal, there could be value.

Then there are ideas that people in manufacturing or sales could use the iPad to roam around factories or give demonstrations on the fly. These sorts of ideas seem possible and all involve having to go through Apple. If the iPad is widely adopted, developers are going to have to increasingly work with and split revenue with Apple. If you thought Microsoft had a competitive advantage with Windows, think about what Apple could have in the future by totally controlling the user experience and applications market.

This week’s New Yorker has a great article (New Yorker digital subscribers click here) by Malcolm Gladwell on entrepreneurship. Gladwell finds that entrepreneurs are actually not the high octane risk-takers that they are made out to be. Instead, successful entrepreneurs are highly rational actors, akin to predators who follow systemized patterns and go after safe prey. The article prominently features John Paulson’s CDS trade but also refers to a number of other fascinated entrepreneurs like Sam Walton and Ted Turner. While the article wont be available online for a while, I thought I’d quote some excerpts that I feel are worthy of discussion.

At 24 years old, Ted Turner became the CEO of his family’s outdoor advertising business after his father committed suicide. The business was actually quite good and threw off a lot of cash while requiring little by way of capital expenditures.

Turner sought to expand his empire and went after WJRJ, a UHF TV station that was down on its luck:

It was housed in a run-down cinderblock building near a funeral home, leading to the joke that it was at death’s door. The equipment was falling apart. The staff was incompetent. It had no decent programming to speak of, and it was losing more than half a million dollars a year. Turner’s lawyer, Tench Coxe, and his accountant, Irwin Mazo, were firmly opposed to the idea… The purchase price of WJRJ was 2.5 million. Similar properties in that era went for many times that, and Turner paid with a stock swap engineered in such a way that he didn’t have to put a penny down.

Most successful dealmakers that have built real empires all have the ability to find deals with great tax treatments. The Pritzkers of Chicago, John Malone of Liberty Media, and Sam Zell have all sought out these types of deals. Turner also recognized these benefits:

WJRJ’s losses could be used to offset the taxes on the profits of Turner’s billboard business. The television station, furthermore, fit very nicely into his existing business. Turner was very experienced at ad-selling. WJRJ may have been a virtual unknown in the Atlanta market, but Turner had billboards all over the city that were blank about fifteen per cent of the time. He could advertise his new station for free.

Most of these entrepreneurs use these deals to pick up NOLs at low prices which drastically reduce the taxes paid by the businesses they run. These boost profitability and gives them an advantage over competitors. Gladwell also seeks out academic research on entrepreneurship, in order to find patterns that are displayed my large groups of successful businessmen.

First, he cites the work of Michel Villette and Catherine Vuillermot (From Predators to Icons). One of the things that Villette and Vuillermot find is that most successful entrepreneurs are not one-hit wonders. Instead, they find some kind of inefficiency in the business landscape and actively exploit it:

There is almost always, they conclude, a moment of great capital accumulation — a particular transaction that catapults him into prominence. The entrepreneur has access to that deal by virtue of occupying a “structural hole,” a niche that gives him a unique perspective on a particular market.

Villette and Vuillermot go on, “The businessman looks for partners to a transaction who do not have the same definition as he of the value of the goods exchanged, that is, who undervalue what they buy from him in comparison to his own evaluation.” He moves decisively. He repeats the good deal over and over again, until the opportunity closes, and — most crucially — his focus throughout that sequence is on hedging his bets and minimizing his chances of failure. The truly successful businessman, is anything but a risk-taker. He is a predator, and predators seek to incur the least risk possible while hunting.

If you take a moment to think about businessmen and investors who have had extraordinary success, they all seem to exhibit this trait. Most great businesses occupy a space in their industry where they are protected by the wide moat of their competitive advantages. Usually, it is a result of growing and growing until you almost monopolize your sector.

John D. Rockefeller saw an inefficiency in the oil refinery market and quickly moved. He realized that by securing rates with the railroad companies, he could at least gain a cost advantage over competitors. He also realized the economies of scale that could be had by acquiring competitors. At the time, running an oil refinery was a terrible business, many became bankrupt. But Rockfeller was able to build Standard Oil with acquisition after acquisition and emerge with a monopoly.

Sam Walton saw that rural communities were not being served by large discount retailers such as Kmart. He didn’t just open one Walmart, he opened many, using airplane flyovers to find untapped markets that would also connect advantageously with Walmart’s supply-chain system. Walmart grew so large that competitors from urban areas were unable to penetrate his geographic foothold. Walmart was then able to enter urban markets with ease and topple competitors to become America’s most successful retailer.

Ray Kroc saw a market for America’s first nationwide fast-food chain as he sold milkshake machines around the country. What he found were great hamburger restaurants run by people with no entrepreneurial drive behind them to actually franchise them. After encountering McDonald’s in 1954, Ray Kroc sealed a deal to become the company’s sole franchisee and grew the hamburger chain outside of Arizona and California. Today, McDonald’s is the world’s biggest hamburger chain.

While Gladwell refers to John Paulson as an investor who has exhibited these traits recently, Sardar Biglari may be a better example. Biglari started his hedge fund using money from a tech company that he started and sold while in college. He then went on to one by one, target fast-food companies that had high concentrations of company-owned restaurants on their balance sheets. Many of these chains were quite old so it was likely that the real estate, recorded at a cost on the balance sheet, was dramatically undervalued relative to their current market values. All together, Biglari targeted five restaurant chains: Western Sizzlin, Friendly’s, Applebee’s, the Steak ‘N Shake Company, and Jack in the Box. Biglari was able to get on the boards and take control of both Western Sizzlin and Steak ‘N Shake, eventually merging the two. Applebee’s and Friendly’s were both bought out by other companies. Biglari’s least successful attempt was with Jack in the Box, but since he only agreed to exchange shares of Western Sizzlin for Jack in the Box, the cost was virtually nothing.

The other thing Gladwell finds is that most entrepreneurs are able to find inventive ways of financing their business ventures:

Giovanni Agnelli, the founder of Fiat, financed his young company with the money of investors — who were “subsequently excluded from the company by a maneuver by Agnelli,” the authors point out. Bernard Arnault took over the Bousac group at a personal cost of forty million francs, which was a “fraction of the immediate resale value of the assets.” The French industrialist Vincent Bollore “took charge of the failing family company for almost nothing with other people’s money.” George Estman, the founder of Kodak, shifted the financial risk of his new enterprise to his family and to his wealthy friend Henry Strong.

For the entrepreneur, cheap and secure financing can drastically improve the chances of an enterprise’s survival. By investing little of his own money, the entrepreneur can amplify returns on his own invested capital while keeping dry powder in reserve for new opportunities. Most successful real estate developers exhibit the same trait as do private equity firms, little equity is actually invested in the properties acquired in favor of debt. This often leaves the newly privatized properties in danger of default in the case of a sudden economic downturn, while keeping the fortunes of the owners largely in tact.

Gladwell emphasizes the fact that Ted Turner was also averse to using cash in his acquisitions. He explains by using Turner’s purchase of the Atlanta Braves as a case:

The team was losing a million dollars a year, and the owners wanted ten million dollars to sell…

He talked the Braves into taking a million down, and then the rest over eight or so years. Second, he didn’t end up paying the million down. Somewhat mysteriously, Turner reports that he found a million dollars on the team’s books — money the previous owners somehow didn’t realize they had… He now owed nine million dollars. But Turner had already been paying the Braves six hundred thousand dollars a year for the rights to broadcast sixty of the team’s games. What the deal consisted of, then, was his paying an additional six hundred thousand dollars or so a year, for eight years: in return, he would get the rights to all a hundred and sixty-two of the team’s games, plus the team himself…

Turner is a cold-blooded bargainer who could find a million dollars in someone’s back pocket that the person didn’t know he had.

Many successful businessmen and investors seek out hidden assets when doing acquisitions. Often, the value of assets are sometimes obscured by accounting or the market climate. One of Warren Buffett’s most famous investments was in the Sanborn Map company. In 1961 the stock made up 35% of his partnership’s assets and gave him a spot on the company’s board. Astonishingly, while Sanborn sold for $45 per share on the market, the company had an investment portfolio of more than $65 per share. At the time, a buyer of Sanborn stock received an undervalued investment portfolio and a map business thrown in for free.

Using research from economist Scott Shane, Gladwell delves into the notion that the entrepreneur is a risk taker and gives reasons for why entrepreneurs fail:

…many entrepreneurs take plenty of risks — but those are generally the failed entrepreneurs, not the success stories. The failures violate all kinds of established principles of new-business formation. New-business success is clearly correlated with the size of initial capitalization. But failed entrepreneurs tend to be wildly undercapitalized. The data show that organizing as a corporation is best. But failed entrepreneurs tend to organize as sole proprietorships. Writing a business plan is a must; failed entrepreneurs rarely take that step. Taking over an existing business is always the best bet; failed entrepreneurs prefer to start from scratch. Ninety per cent of the fastest-growing companies in the country sell to other businesses; failed entrepreneurs try selling to consumers, and, rather than serving customers that other businesses have missed, they chase the same people as their competitors do. The list goes on: they undermine marketing; they don’t understand the importance of financial controls; they try to compete on price. Shane concedes that some of these risks are unavoidable: would-be entrepreneurs take them because they have no choice. But a good many of these risks reflect a lack of preparation or foresight.

Some of the reasons for failure may seem counterintuitive to a person who is seeking to start their own business. Many may balk at the prospect of taking over an existing business, but if it is a forced sale due to owner’s health or a decision to retire, a budding entrepreneur may have the opportunity to acquire a good business at a low price. This kind of thinking requires the entrepreneur to employ the kind of rational judgment that is totally counter to the cowboy image the media perpetuates.

Another of these traits is not caring what other people think. Gladwell notes that many successful entrepreneurs are willing to risk their personal reputation for their business. He contrasts the behavior of banking CEOs who kept piling up bad investments because they feared standing out from the crowd with Sam Walton’s decision to seek financing from his in-laws a second time after failing at his first venture:

Villette and Vuillermot point out that the predator is often quite happy to put his reputation on the line in pursuit of the sure thing…

If an awkward family reunion was the price Walton had to pay for a guaranteed line of credit, then so be it. He went out of his way to take a personal risk in order to avoid a professional risk. Reputation, after all, is a commodity that trades in the marketplace at a significant and often excessive premium. The predator shorts the dancers, and goes long on the wallflowers.

If there is one thing that is really representative of the entrepreneurial stereotype, it is the unflinching persistence that seems to be exhibited by all the examples used in the article. Gladwell ends with a story about the lengths Turner went to, to take back his family’s outdoor advertising business:

He hired away the General Outdoor leasing department. He began “jumping” the company’s leases– that is, persuading the people who owned the real estate on which the General Outdoor billboards sat to cancel the leases and sign up with Turner Advertising. Then he flew to Palm Springs and strong-armed Naegele into giving back the business…

Naegele, by the way, asked for two hundred thousand dollars, which Turner didn’t have. But Turner realized that for some o ne in Naegele’s tax bracket a flat payment like that made no sense. He countered with two hundred thousand dollars in Turner’s Advertising stock…

“I had kept the company out of Naegele’s hands and it didn’t cost me a single dollar of cash.” Of course it didn’t. He’s a predator. Why on earth would he take a risk like that?

Here, Turner really serves as an example for all entrepreneurs. His father had sold General Outdoor and committed suicide shortly afterwards. Such an event must have been emotionally jarring for someone like Turner, but he managed not to be constrained by grief and moved into action. All of his decisions, from poaching personnel to exploiting his adversary’s tax status exemplified the kind of clear-sightedness that is necessary for long-term entrepreneurial success. For the entrepreneur and investor, being able to keep calm emotionally is an absolute need when faced with the daily competitive pressures and changing landscape of the market.

The entire article is worth the read, I would suggest seeking out a copy from your news stand or purchasing a digital subscription, these excerpts are just a small part of it. This is especially true if you are interested in John Paulson. Gladwell dedicates a large part of the article to discussing how and why Paulson managed to earn billions of dollars by purchasing credit default swaps.

One of the reasons that M&A deals end up performing so poorly is the fact that CEOs often allow their emotions and egos cloud their judgment during the process. This often leads to CEOs raising premiums or issuing shares endlessly, hurting the value of shareholders. Warren Buffett seems to believe that the current actions by Kraft (NYSE:KFT) in pursuit of Cadbury (NYSE:CBY) could do just that. And as a holder of almost 10% of Kraft, Buffett does not seem to agree with the current acquisition strategy (Bolded for emphasis by me) :

Omaha, NE (BRK.A; BRK.B)—Berkshire Hathaway has voted “no” on Kraft’s proposal to authorize the issuance of up to 370 million shares to facilitate the acquisition of Cadbury. Berkshire, taking into account both its own holdings and those of its pension funds, believes that the 138,272,500 Kraft shares it owns – 9.4% of the total outstanding – make it the company’s largest shareholder.

The share-issuance proposal, if enacted, will give Kraft a blank check allowing it to change its offer to Cadbury – in any way it wishes – from the transaction presented to shareholders in the proxy statement. And we worry very much that, indeed, there will be an additional change from the revision announced this morning.

To state the matter simply, a shareholder voting “yes” today is authorizing a huge transaction without knowing its cost or the means of payment.

What we know with certainty, however, is that Kraft stock, at its current price of $27, is a very expensive “currency” to be used in an acquisition. In 2007, in fact, Kraft spent $3.6 billion to repurchase shares at about $33 per share, presumably because the directors and management thought the shares to be worth more.

Does the board now believe those purchases were a mistake and that Kraft’s true value is only the current price of $27 per share – and that it is therefore fine to structure a major acquisition based upon that price? Would the directors use stock as merger currency if the price were, say, $20 per share? Surely the true business value of what is given is as important as the true business value of what is received when an acquisition is being evaluated. We hope all shareholders will use this yardstick in deciding how to vote.

Our understanding is that Kraft must announce its final offer for Cadbury by January 19th. If we conclude at that point that the offer does not destroy value for Kraft shareholders, we will change our vote to “yes.”
At this time, however, we believe no shareholder should vote “yes” when he can’t possibly know what he is voting for.

Berkshire Hathaway and its subsidiaries engage in diverse business activities including property and casualty insurance and reinsurance, utilities and energy, finance, manufacturing, retailing and services. Common stock of the company is listed on the New York Stock Exchange, trading symbols BRK.A and BRK.B.

Berkshire Hathaway Press Release (PDF)

When a CEO looks to use stock as currency, it is important to pursue a sound course of capital allocation that does not send value down the drain. One of the greatest corporate capital allocators was Henry Singleton of Teledyne. Singleton recognized when his own stock was overvalued or undervalued. When overvalued, he had no problem with issuing stock when it was overvalued and using it as currency for acquisitions. This is counter to Kraft’s strategy of buying back shares at $33 and issuing shares at $27.

If you would like to read more about Henry Singleton, feel free to check out the following article via Scribd.

An interesting look at the credit card industry:

Unfortunately, the Bank Analyst must remain anonymous. I will say that he works at a large buy-side fund and comes from a value investing background. I think that this interview went really well and you’ll enjoy it. The interview just has a ton of concentrated information about how to look at banks and then perspectives on the sector. I transcribed this from a recording of our conversation, so I everything below is pretty close to word-for-word what was said. I tried to get all questions that were submitted to me answered. Questions and my comments are in bold.

How do you gain a circle of competence with banks? Where do you start?

Keep it very simple. Banks or financial institutions are based around borrowing money and then lending it. So that’s going to be masked by all different types of weird funding mechanisms and odd assets (securities and lending structures). The accounting treatment and regulation will be tricky.

The learning curve especially with the crisis means it’s hard and always evolving. With that giant pot of knowledge you want to keep it very simple. Start out be looking at small micro banks, there are banks trading that might only have 10 branches that operate out of one geography. You can learn that one particular geography and all the macro idiosyncrasies of it. Plus, you can probably talk to management. Keep it simple, find banks that focus on just mortgage lending or commercial and industrial (C&I) lending and master that. Then if you master it you can branch out. If you master mortgages you can branch out to commercial real estate (CRE), then C&I.

Then you could do something like read a Bank of America 10K. They own every type of business within financials. So it might look confusing as a whole but if you think about it individually they are like separate monolines that are operating as a whole.

But yeah definitely start with the simpler banks at first.

What ratios are you looking at the most when examining banks? Do you use the Texas ratio at all given how it has helped signal banks that will need to raise cash in the past?

We don’t really use the Texas ratio specifically. The general ratios that the banks provide you are ok but obviously you can’t just go off of that. There’s much more investigative work. It all starts with a detailed look of the loan/securities portfolios, so type of loans and where they were originated in terms of geography. We look at the different delinquency buckets, non-performing assets, charge-off numbers and make assumptions. It’s a very macro-economic driven process.

Non-Performing Asset (NPA) ratios and charge-off ratios and the rates of their change are important but ultimately it’s the capital relative to the banks assets that’s most important. If a bank has a 4% capital ratio (TCE / TA) and the bank has 5% losses the equity is wiped out assuming they don’t earn their way out. Texas Ratio basically says if all non-performers lead to charge-offs then what percentage of tangible equity would be wiped out, so sort of the same thing.

Do you use any different metrics for regional banks?

No. I wouldn’t say we use any different metrics. Regional banks may not have as many loan categories as the bigger guys. There can be less to look at and obviously its specific to the region. If there is a large discrepancy between the general macro and the regions macro it can make a major difference (meaning a Florida bank may relatively underperform a bank in NJ)

Thomas Brown of Bankstocks argued that the charge-offs to loan reserve ratio had no meaning due to variations in accounting treatment. Can the analyst describe a better criteria for measuring loan reserve adequacy?

There’s some merit to his argument. I’ll give you a simple example: When a bank makes a credit card loan, the reserve to the loan should be higher in theory because it’s an unsecured loan. If it’s a mortgage you can afford to charge off less because there’s collateral backing it up and you’ll have some of the loan recovered in a sale. Obviously the severity is dependent on the economy (if home prices go down). Generally simple reserve ratios may not tell the whole story but when they are headed in one direction quarter after quarter it’s telling you something. If I recall correctly from the specific article where Brown discusses the topic he talks about FHN and how based on reserve ratio, reserves look inadequate but if you look at how those reserves are allocated it seems sufficient. Now you can try to be a hero and pick names that way and claim its thorough analysis but it doesn’t work so well in a banking crisis environment similar to the one we went through.

So should capital adequacy ratios factor in black swan events then?

See – no one knows what that correct capital adequacy ratio (CAR) number is. You don’t know what the severity of the next crisis will be. I’m in favor of keeping the reserve requirements higher than they have historically been. One of the reasons we got in trouble is because the system got way too levered.

How important do you view the funding of deposits? How do you incorporate sources of funding into your investing decisions?

Some people value banks based on deposits — I don’t. I don’t think anyone uses it as the end all valuation. Deposits can make or break a bank. They generally tend to be the stickiest and lowest cost source of funding. With wholesale funding, you’re waking up in the morning praying that some institution is going to keep lending to you. With deposits, you don’t have to worry about that as much.

You want growth in savings loans versus high yield CDs right?

Yeah — the type of deposits is important. If a bank sets them up with hot money CDs, it’s really no different than wholesale funding. GMAC did this. You don’t want a banking institution that does that. You want a depository that people trust and are willing to give you money interest free.

How do you value a bank? Most traditional investors look at things like DCF valuations or try to come up with a Ben Graham style assets-based valuation, but banks are different right?

It’s rare to see a bank analyst use a DCF. We mostly use an earnings model. We then attach a multiple, so what a lot of analysts are doing is attaching the historical 10-12x multiple to normalized earnings.

A simple way of getting an earnings number is by taking a ROA (Return on Assets) percentage and assuming some type of asset growth (negative or positive) and then multiplying the ROA times assets times the growth number. Then, take that number and divide it up by the shares outstanding to get some kind of an EPS figure.

A more detailed model assumes some earnings asset level and net interest margin (NIM) to get net interest income. To get non-interest income you just assume some growth rate off of the fee line items. Then, assuming something on provisions and expenses to get a net income figure. Thats the basic idea and it incorporates a lot of assumptions on the macro and regulatory environment.

During this crisis I think people looked at banks in this manner:

There is a credit/capital concern > people start looking at banks based on tangible book > the concern becomes whether capital is enough. You make your own stress test. If banks pass that you might want to invest in them. Obviously you have to net that against how ouch they will earn too. But trying to earn your way out didn’t really work for Japan.

Ulimately, normalized earnings will depend on GDP and unemployment. If it ends up being robust (so GDP growth rates are high and the unemployment rate goes down) then banks will win but the biggest risk to bank earnings going forward is the level of earning assets. If earning assets decline, normalized earnings will not be as high. The decline in loan balances is something I’m paying particularly close attention to this quarter.

So if a bank has 14% capital and they currently have losses of 3% you are probably in good shape assuming they are not lying or pushing losses into the future. But a bank of that sort might not be cheap either, which can make it a waste to invest in.

What kinds of things do you usually ask management on calls and visits?

Ask whatever you can’t get out of the 10Q and 10K. Understand the intricacies of the business. Find out about specific accounting treatments and things like granular details on their loan portfolios.

Also, trying to gauge how they see the macro-economic environment. The best thing to ask management is to ask what they see in their locale. Look at Case Schiller and see what a specific housing market is doing and then ask a bank there about it. They might say that even if house prices are going up, the unemployment situation still sucks so there’s no improvement.

In Margin of Safety, Seth Klarman says that value investors don’t invest in banks often because their asset books are too opaque. How, when you’re analyzing a bank, do you make sure the assets have a credible margin of safety?

It depends on a lot of factors. 1. The types of loans and geography 2. How loans are performing. 3. Management’s track record in originating loans and honesty. 4. How the macro is performing and 5. How aggressive/conservative management is in working through problem loans.

So dealing with the transparency, that’s a good question. Investing in financials is more of a gamble than any other category. You will simply not have the transparency you have at other simpler businesses. In other sectors management on conference calls can give you line item guidance that you can just plug in your models to come out with next quarter EPS within a small range of error. How many financial management teams got it wrong or thought they wouldn’t be the last one’s holding the bag during the crisis? I remember hearing Ken Lewis (CEO of Bank of America) talking about how the recession will end in 2Q08. And this guy basically gets a real time update on the economy on a daily basis.

So you want a wider margin of safety. If you would buy a company at 6x P/E, you might want to aim for 4x P/E.

Financials are truly a different animal in my opinion. There is no advantage in investing in financials (meaning you are not getting superior moats or higher ROE businesses compared to other sectors) If you thought the market was dead cheap in march for example, there were plenty of businesses in plain vanilla sectors (retail) that had rises greater than or similar to financials and were much easier to understand. Assuming these stocks were undervalued and haven’t gone up for speculative purposes, you can see that car rental company Avis Budget Group (NYSE:CAR) is up 11 fold since its low compared to Bank of America which is up 6x. I would say Avis is a lot easier to understand than BoA.

So why did value investors get it wrong?

As a value investor, investing in a financial requires really getting comfortable with the macro-economic situation. So unless you’re doing some kind of arbitrage (market-neutral) play, you will have to look at the macro. If you want to ignore the macro because Warren Buffett says it is useless then you want to stay away, especially if you’re not benchmarked or don’t have a mandate to invest in financials.

I think that some value investors refused to believe that this time it is different. Also, they just didn’t understand the risks involved with some of the intricacies in financials. Bruce Berkowtiz talks about how he didn’t understand AIG when he read about their derivatives and said pass.

I think that other value investors, especially the ones who decided that AIG was cheap let those risks pass by them. Or they looked at history and said “Okay, this bank trades at 1/2 book and based on history its never been cheaper.” They were wrong.

What would happen to banks in a hyper-inflationary scenario in which the 30-year Treasury yield goes to 15-20% or higher, as Julian Robertson has suggested?

In a hyper or super high rate environment, it will not be good for financials and equities.

The first step would be that asset sensitive banks where loans/securities re-price faster than their liabilities would win temporarily. If you read what SCHW has said, for every 100 bps rise in rates they generate 600 million in net revenues, which pretty much fall straight to the bottom line.

Eventually the dynamic that would kick in would be that depositors would demand higher rates. If rates are 15% depositors wont want 3% CDs. So right there, funding costs would go up.

For a bank to make money, it’s usually an 80/20 split. So, 80% comes from interest income and 20% from fees. Since banks typically generate income from net interest income, they’re going to have to make loans that are higher than their funding costs. The argument is, what homeowner wants to pay a 15% mortgage in a 10% unemployment environment? Credit card rates have already gone up — you’ve seen Wells Fargo and others already do this to try to protect against potential regulatory changes, so that they can keep ROEs closer to a historical level.

I’d argue though that loan demand would collapse. Unless it’s a necessity but I don’t think anybody can raise prices high enough to match that kind of rate environment. Would you pay $20 for a Starbucks coffee? I don’t think so.

So the basic idea here is that nobody will be able to afford those loans and the demand for credit will fall?

So yeah, when funding costs become elevated it’s tough for them to make loans higher than the funding cost. A coffee shop isn’t going to take a loan to buy an espresso maker when the rate is 15%. To make money above their 15% cost you would have to raise prices to the point where no one would purchase a latte. Will that espresso machine make a 15% return to make that a viable expense? I doubt it. Initially, when rates start to rise, asset sensitive banks will win.

So let’s say a bank out there has locked in 5% funding base for the next 10 years. If rates go to 20%, they’re safe with their 5% and they’ll be able to price loans above that easily. Or a bank can become the lender to the government, but if all you’re doing is funding the government that wont work in the long term, as the economy would collapse.

The trade in financials has largely been long large money center and short regional banks. Do you see that trend continuing going forward?

If you start from the beginning, that trade has worked relatively. The best trade was to just long the whole sector. Now I would say that trade is worth holding onto. Ultimately, what I see on the long side is truly diminishing. On the short side there is some stuff but its primarily valuation related.

I want to make clear though that the idea to go long money center banks has had the margin of safety diminish by a lot. I’ll give an example:

Smart and dumb analysts think that Bank of America (NYSE:BAC) is going to earn around $2.50 to $3.00 in 2011 or 2012. What happens if they’re dead wrong? What happens if they earn $0.90 cents? Then you are clearly overpaying for the price it is at today, $17. But when the stock was available at about $3 it was either trading at 3x or 1x. It was very cheap at both of those multiples.

It’s scary because everyone is betting on Bank of America and I don’t like to bet on a horse that everyone else is betting on. If there is a chain reaction of sells on that name it can contract quite a bit.

How worried are you about regionals with large commercial real estate (CRE) exposure as we progress through what seems to be the next set of fundamental problems? And on that note, which regionals would you be most afraid of here?

In the beginning of the year people thought about banks specifically on the basis of what are the banks with early credit stage issues – housing, consumer type loans (credit cards) versus banks with later stage issues like CRE.

So for example: If you see people moving onto land, they’ll build houses. And if companies see houses, they’ll build commercial real estate and expand their businesses there. So in theory, it’s consumer loans that go bad and then goes CRE and C&I. So for regionals, later stage issues are a larger portion of their loan portfolios. We haven’t seen that hit as much as the early stage credit stuff.

CRE is an interesting animal. 1. There’s a lot of weird accounting 2. The structure of the loan itself. So there are these mini-perm loans for example where on the third or fifth year, the principle balance of the loan is due. A lot of these loans were made between 2005-2007. You still have 2009-2011 where things will come due. But a lot of these mini perm loans get extended out a year. So instead of going to non-performing they just get extended out and to all of us we continue to think they are performing.

Fifth Third (NASDAQ:FITB) is one regional that I’m kind of worried about. In general, right, if you’re going to look for CRE issues there’s a few categories: retail, lodging, industrial, and multi-family. Multi-family probably won’t do as bad as other ones because it’s harder to get loans to buy a mortgage. So more people are going to move into apartments in theory but it will still be hit. That might not do as bad as the other types of loans. Retail will obviously take a hit with consumer spending dropping and unemployment levels elevated. Here are some numbers: a basket of regionals – CMA 22.4%, MTB 25%, Regions 21%, Synovus 28%, Zion 35%. If you look at Wells Fargo 10%. Citigroup it is 2% and for BoA it’s 5.75% of loan portfolio. So those guys are pretty diversified versus the regionals that have a ton of CRE exposure. So you have to drill down and figure out the type of CRE they have the geography of it.

So basically it’s a way for management to hide delinquencies using weird accounting treatments?

Exactly. I’d point to the FDIC bank failures. A lot of the failed banks had 2-4% delinquencies in CRE and then a quarter later delinquencies shot up to 30%!. So you don’t really see that in other categories as the increase is gradual Q/Q.

Will majors participate in open market M&A or wait for the FDIC gain deposit share?

A lot of consolidation you saw with PNC (NYSE:PNC) taking over Nat City, Wells taking over Wachovia, I would argue that that type of M&A is less likely in the near term. More of the FDIC bank seizure type will be common

What about straight up mergers/takeovers?

Banks are still worrying about filling holes in their capital base. Even though equity markets have opened up, these guys would likely have to raise money to take over a large-scale bank. Look at Wells Fargo. Once they put on all their off-balance sheet exposure they’ll have a TCE ratio closer to 3%. They’re already in the 4%-ish range. Some of these guys are already too big — a single bank cannot own 10% of the depositor base of the US. You can only do that if you grow the deposit base organically. Not through takeovers, though I think that rule wasn’t considered last year

Can you talk about how you think regulatory / compliance changes that are on the horizon will affect banks? Any key things to watch out for?

One thing that’s known by the industry that everyone is expecting is rules on new capital adequacy ratios. Capital ratios will go up, the system cannot lever as much as it did before. That’s one thing. Fees are going to get hit (think deposit fees, credit card fees). Who knows what will happen if the Consumer Protection Agency goes forward.

I think normalized earnings will go down because of this. I think provisioning rules will change too. When times are good, banks can’t build reserves too high. FASB will argue that that they’re trying to dodge taxes. Do you know how that works?

No I don’t — let’s go into that a bit.

Okay so, when you have to build your allowances for loan losses, it comes through the provision expense. So banks have a reserve set aside, Bank A has $1000 in reserves with $100 in charge-offs. $100 comes out and the reserve is $900 now. If you want to replenish you need to add $100 but if you want to over provide for that you need to add $101 or more, which all comes out of net income.

In good times, some banks might want to provide for more if they think a crisis is coming. The less they provide the higher their earnings will be. The more they earn, the more they pay in taxes. FASB doesn’t want them to build reserves to an amount they think is unnecessary.

It goes back to what Japan was worried about. Their loans stayed in trouble for a long time. I think 25% of Japan’s tax receipts came from financial reserves. So the government didn’t want them to provide for bad loans.

So yeah — it would severely dent tax revenues. So that’s the dynamic here, there’s this quirk in the accounting and regulatory situation.

Exactly. If a bank had foreseen the crisis, they would have had pressure to actually lower reserves. So I think that will change for the better now and that banks will be able build reserves at a higher rate than before.

How do you deal with the government interference and its skewing of natural competition among banks? (i.e.: having the entire mortgage market in 3-4 banks)

Yeah, so there’s always a stigma with government. I think that’s why banks got so depressed in January and March lows. There were a lot of nationalization fears and the stress test looming. Nat City always boggles me because they had 8.7% TCE ratio, they were one of the highest among peers/large banks. For some reason that bank had to basically be sold to PNC. It could have been a depositor’s run.

So you think the government overreacted in cases?

I don’t think government is good at running businesses. So if they start telling banks whom to originate to I wouldn’t want to be a shareholder of that bank. I do think it will have some implications on the lending business going forward.

One thing to add to that, some people are definitely giving the banks that have excessive intervention less of a multiple. Bank X might be worth 8x but Bank Y that paid back TARP might be worth 10x.

Do you agree with that?

Yeah I do. If government flexing their muscles influences operations, if it becomes very big, then yeah. I don’t think government will be as efficient although I don’t think management of banks themselves aren’t so competent or efficient.

Yeah I thought it was interesting that Citigroup had to sell Phibro, even though it’s a profitable and well-run business unit.

Yeah that’s one decent example. Another thing — if you have more programs or initiatives that relax loan standards. If you can’t pay 20% down you shouldn’t buy a house, no matter what the American dream entails. America’s sort of becoming one big bank. They’re doing subprime lending with the FHAs.

What’s your best long and short for the sector? Themes?

I currently ask two questions:
1. What financial institutions are pushing problems to the future?
2. What banks are trying to work through their issues right now and be prepared for an uncertain world?

So how do you tell that?

Find banks that are aggressive in marking down their books and aggressive in raising capital. Or banks that didn’t partake in this excess during the credit bubble. You’ll find these banks; they might not be very popular. Look for well-capitalized institutions that are ready to pick off credits from weaker institutions. It’s sad to say but look for well-connected management. Look at Goldman Sachs (NYSE:GS), a lot of people complain about Goldman, like with that Rolling Stones article. But if you think about it, all those negatives are reasons I’d want to own them at the right price.

So for management, look for guys that are liked by politicians and the public?

So if Warren Buffett were to fall tomorrow, a bunch of guys would be saying all these great things about the life he lived. Angelo Mozilo of Countrywide? Probably not so much. In banking, honesty is super important. It’s important everywhere but I mean — look at IndyMac’s CEO. He was so positive up till the bank collapsed. It’s very unfair and really tough. Some investors really relied on his word and it’s very sad. The good thing about having this period in history is that you can see what management teams handled it well. So if the problems get worse, you can use this period to see if they passed.

I would argue that future crises that come about are likely to be worse. With the way the US is acting these days, with the amount of debt they’re taking on, we’ll probably see more problems in the future.

Commerce Bancorp (formerly CBH) used to be a unique bank that had a different business model. If it were a standalone company now, would it have been affected the same way as most of the big banks? Also, would it have taken more market share from the likes of BoA and Citi.

The thing is, when you go through a system-wide crisis, even small banks are bound to be affected. People always praise Wells but I highly doubt that they picked off the best credits in California while Countrywide and IndyMac were left holding the crap. When you have that big of a loan portfolio, I doubt that whole number is good credits. Obviously it hasn’t been.

So Commerce, their model, Vernon Hill was definitely an innovator. Bank Atlantic tried to mimic it exactly, UMPQ is doing something similar. Ultimately though, it’s the type of loans you make that can bring you down. You can be the most innovative banker in the world but if you make bad loans you’ll go down. Commerce also benefited from having a geographic concentration in the Tri-state area.

Are there any banks in particular that stand out in doing new, innovative things? The future of banking will be different than it is today, which banks are going to be ready for that new future?

I’m sure people can disagree but I’d argue how innovative can you really get in a borrowing/lending model. The medium is changing. We’re seeing more Internet banking and maybe something happens in mobile. When is the last time you actually stepped into a bank branch? My parents do, but not so much the younger generations. There’s banks that offer iPhone apps, so that’s the type of innovation I see but nothing too big. You wont get credit for innovation when you’re in a banking crisis.

Mostly, innovations are used to get cheap deposits. If there is a bank that can innovate and do it correctly, then it can work well. Commerce is a great example of one that did achieve it. Their efficiency ratio was higher than most peers but that’s because they kept their bank open 7 days a week and they made it so you really wanted to visit their branches. They used nice colors, had super friendly tellers (they weren’t stuck behind bullet proof windows or a mini gate), and they didn’t make branches look like a post office or a jail cell.

Their whole idea was putting more money towards non-interest expense but they were able to charge less for deposits since they were more convenient. It definitely worked. If you could invest in safe assets you could earn a wider NIM than peers.

The thing about Vernon Hill was that he wasn’t in the banking business forever, he owned Burger King franchises so he brought over that customer-driven model to banking. But if you run into the storm like we did now, innovation is not a high priority on bank executives’ minds.

If you look at innovation from other areas, like tech, you’ll see guys in college who are really bright that are making websites trying to innovative banks.

Yeah I wanted to talk about that — I always see guys, especially from valley tech startups saying how we need to take the start up model to banking ad really innovate things on that end. Every time, I think this is a recipe for failure with all the regulatory hurdles and work involved.

That’s another good point. It’s a heavily regulated industry. So for someone in college or high school that has a bright idea for starting something in the financial sector, they’re going to go through more capital and regulatory barriers than someone trying to build something like Facebook or Twitter. The roadblocks are just a lot higher.

A lot of times when there’s innovation in financials, it usually comes from within the banking system itself. So it is some guy who has been there for 10 years who sees something and acts on it. But it’s almost never from guys on the outside that think of something one day while sitting in their college classroom.

I would argue that there’s simply a smaller number of brains devoted to thinking about new ideas in banking and it’s mostly limited to people who are already in the financial world because it is within their competence.

What about innovative companies within banking?

There’s definitely people like Dick Kovacevich of Wells Fargo who talks about cross selling at Wells Fargo. There are people who argue that it doesn’t work but to him it’s like the Holy Grail. I’d argue to some degree it has worked because Wells Fargo probably has the best funding out there. I don’t have much experience with their branches since I’m on the east coast but we’ll see how things go with this Wachovia integration.

One thing that a lot of value guys got wrong is that they focus too much on qualitative factors like culture and things on the surface of the business model too much. They focus so much on the positives that they aren’t looking at the risks looming. When you’re sitting there analyzing tech companies, a lot of tech companies have good balance sheets. You’re not trained to look at balance sheet risk. David Einhorn did better on financials than other guys, because they set themselves up to look more at downside. Tom Brown focused too much on culture / qualitative factors and didn’t consider the macro/quantitative reasons that could destroy a bank.

What are you reading right now?

I’m reading Just What I Said by Carrol Baum, a Bloomberg Economics columnist. It’s pretty basic. One thing I learned about banks is that macro matters so much more than you think with banks. You’re almost a macro investor, so on that note I’m also reading Alchemy of Finance by George Soros.

One more basic/beginners book that I really like is Peter Lynch’s One Up Wall Street, that was a book that had a big impact on how I looked at investing when I was younger.

Thank you very much for giving your time for this interview. I know that my readers are going to enjoy it.

(Update: the interview is up now over at Charlie Rose)

A while back, when talking to a friend of mine who works in advertising, I mentioned that I thought Hulu would be an amazing place to work at in this point in time. Hulu is one of the rare cases where you see traditional media companies “getting it” where they embrace new technologies that work really well. Hulu has had huge success and recently its been reported that advertisement buys on the website are most costlier than buying space on TV. My guess is that this is the beginning of a long-term relationship between Hulu and its viewers. So far the company is creating great brand equity by providing online users with a place to view high quality online content in a really enjoyable manner. I don’t see their model eroding anytime soon.

As value investors, we spend an awful lot of our time looking at distressed sectors of the economy. I’ve spent quite a bit of time looking at media companies and found myself a bit confounded. Take a company like News Corp. Rupert Murdoch is arguably one of the savviest media operators in the business. In general, News Corp boasts a more robust digital portfolio of businesses than others — but still they face some trouble. The company’s large newspaper holdings have seen declining ad revenue and even their big media acquisitions like MySpace have faced troubling headwinds as Facebook erodes their user base.

Hulu though, seems to be a prime example of a new online business that knocks it out of the park. Originally started a joint venture between News Corp. (27%) and NBC (27%), Hulu now includes Disney (27%) and Providence Equity Partners (19%). Basically every major TV network except for CBS and The CW.

When I look at media companies, especially in this environment, my first aim is to normalize earnings. It’s tough because the way we consume media is shifting and the new methods of consumption aren’t always monetized well enough. It used to be that you couldn’t count on online monetization because media companies hadn’t figured out but now I think that’s rapidly changing.

CHARLIE ROSE: What is going to be the business model for the monetization of content on the Web?

JASON KILAR: I think it’s going to be a number of things. You know, clearly, when you look at Hulu today, we have a free ad-supported model, and I think that happens to be the biggest. If you take a look at the way the premium content is monetized, there’s a lot of different models out there. Sometimes you pay for an individual episode, for example on iTunes. Other times you pay for a
subscription. And other times it’s free ad- supported.

And if you look at just in the U.S., it’s about a $57 billion industry with regards to ad-supported premium content. That’s the biggest pond.

CHARLIE ROSE: And what is defined as premium content?

JASON KILAR: Premium is — the way that I define it is, it’s done by people who do this for a living. Which doesn’t necessarily mean that it has to be on television. There’s a great example of premium content called “Dr. Horrible’s Sing-Along Blog,” which is created by a guy named Joss Whedon, who created “Buffy the Vampire Slayer,” he’s doing “Dollhouse” right now. He did that on his
own, on his own dime, during the writer’s strike.

That’s premium content. You won’t find it on television, but it’s absolutely premium.

CHARLIE ROSE: Right.

JASON KILAR: So with regards to the business models, I think you’re going to see a lot of different flavors of it. There is going to be free ad-supported, which I happen to think is the most ubiquitous one and the largest one in absolute dollar terms, but there’s also a lot of other models that will be a part of monetization on the Web, including a la carte, subscription, and variants thereof.

The content monetization model that Kilar talks about is akin to the freemium model that’s tossed around a lot by people like Fred Wilson where there isn’t just one system of pricing. Instead you see these tiers, the lowest being free and then it scales up from there. I think that freemium has a tremendous amount of potential, the trick though is to make it so there are real incentives for users to opt for the premium offerings.

One of the really great points that Kilar brings up is that now, media is becoming more of an impulse response business:

JASON KILAR: At one source. So there’s — I’m a big believer that media is an impulse business. You don’t need “30 Rock” to live another day. It’s not like food and clothing and shelter. And I love “30 Rock,” but it’s discretionary. And so the fact that it’s an impulse business means that to me, if you can make it easier to consume, people will consume more of it. So I think the a-ha moment for consumers… was that basically they could consume “30 Rock” when they wanted. When it was convenient after the kids went to sleep or in the morning when they had a break. And that’s very liberating, it’s very empowering, and I think at the heart that’s a big part of the Hulu value proposition.

One of the things that I think is a real feat on the part of Hulu is creating a really well designed and easy site. I originally had the opportunity to beta test it and told everyone I knew about the service and how awesome it was. Sure, some people remarked that they already used similar sites online but typically these were hastily put together and often made the user experience frustrating. Hulu looks and works really well which makes it perfect for this shift towards impulse consumption. The easier these are, the more likely users are to use them.

CHARLIE ROSE: Are we moving to a point where there will be no sort of appointment television, no real-time television?

JASON KILAR: If we were to fast forward, I think that programming is always going to be a healthy mix of event programming and on-demand programming. There’s certain things like scripted dramas that — they’re either topical or such water-cooler moments that I think that they’ll be consumed within 48 hours. You don’t have to consume them at 9:00 at night, but you want to consume them within the first couple of days so that you can talk to your friends about it. The Susan Boyle phenomenon on “Britain’s Got Talent.” You needed to consume that within the first 48 hours to be in the know.

And so I think that for high-quality scripted content, that will be sort of an on-demand environment.

But you look at a lot of programming today, there’s a move to having it be an event program, because there’s value in that. “American Idol” is a great example. The finale of “American Idol,” that’s event television. And the Super Bowl, that’s event television. So, it’s not just sports, but there’s also, I would argue, a big swath of entertainment that’s also event television.

I think that Kilar nails it on what is going to happen with TV viewership. Certain forms of content like sporting events are always going to be consumed live. Shows like Lost where you have a cultish following are likely to be consumed the instant they air, just because their viewers are constantly awaiting their next fix. Other forms of content may not be consumed when they air. I see this being different for everyone though. I think that the lower you value a TV program, the less likely you’re to watch it the instant it airs. If you think about it though, this is going to be beneficial for content producers because it increases the likelihood of their mediocre offerings to be watched on demand with services like Hulu. Whereas before, the program may have been cast aside for lack of interest, now you’re more able to obtain followers. In the long term this is a definite benefit for media companies because it means the playing field becomes less cutthroat and that viewership actually increases (as should ad dollars).

On Newspapers:

JASON KILAR: You know, now that said, there’s a lot of smart people working on the newspaper side of the coin to develop new models.

CHARLIE ROSE: What’s your best guess the way that will end up?

JASON KILAR: So, I think that there’s going to be devices. The Kindle gets a lot of press right now.

CHARLIE ROSE: It does. So — go ahead.

JASON KILAR: Deservedly so, in that they are creating a model that has people get a very valuable thing– which is newspapers like “The New York Times” and “The Wall Street Journal”– on a device whenever people want to consume it, whether on the subway or what not. And they charge people for it. So that’s the beginnings of a business model. I know there’s a lot of contention about well, who gets what, how much does Amazon get, how much does the newspaper get?

CHARLIE ROSE: Well, the contention is not so much who gets what, it’s how much Amazon gets and how little they get.

JASON KILAR: There you go.

CHARLIE ROSE: As you know, because you were there.

(LAUGHTER)

JASON KILAR: I’m very aware of both sides, it turns out. And so that will play itself out, and I’m sure there will be plenty of drama, but these things do sort themselves out. And so I think that there — there’s good news, by the way, in that future.

So Kilar basically has two positions. Keep in mind that Hulu does not produce any of the content on their site and they don’t plan to ever start producing content. They just try to make it so that the content is easily seen which benefits the producers and earns them a cut of the ad fees. He thinks the Kindle is probably the future for newspapers. This might be because of his past experience working at Amazon. I think though that if you change the medium, people may be more likely to pay for news.

What I mean is that people are probably more likely to pay for a paper newspaper than a website subscription. Still though, we see paper subscription rates declining. What a device like the kindle would do is cut out a lot of huge capital intensive costs. The machinery and staff needed to do the actual printing and physical distribution would be cut.

The trick, like Kilar rightfully points out, is figuring out the balance in payments between the newspapers and Amazon or the other device makers.

Monetizing social networks:

JASON KILAR: I think that is fair to say. That is fair to say. And I think
the two — there’s nuance between the two. They’re not — and this is just my assessment. I think you would certainly need to ask them for their thoughts on the topic.

When I take a look at it, the situation is, as you say it, which is an enormous audience, but not an enormous advertiser reception yet, with regards to those companies.

On the one side with YouTube, I think a lot of it has to do with the environment and the content, in that advertisers tend to want to be associated with a certain type of content, which is that they know very well it has a certain quality associated with it that, quite frankly, that quality has a halo effect to their brand and their brand message.

CHARLIE ROSE: And that’s the window that you guys found? This opportunity you guys found?

JASON KILAR: And that’s exactly what we focus on. And so that’s the distinction there.

On the Facebook side, I think it’s a bit of an evolution, in that that company, which has clearly done amazing things, was, I believe, as an outsider looking in, was founded on a culture that was obsessive about the users. And they built a service that is very valuable for users, and that is to be
applauded.

I think challenge for Facebook is to develop a culture that has the advertiser and the ad service be as strong a part of their culture as the user obsession is. And that is a trick, because cultures are not very easy to change. They’re sometimes almost impossible to change. But that is I think the challenge
that they’ll have to.

CHARLIE ROSE: So, what’s the way out for them?

JASON KILAR: The way out is literally for Mark Zuckerberg– and he’s doing it, I believe– is to make sure that that’s a part of the culture, that the quality of the advertising service and the efficacy of the advertising service has to be talked about as much internally as the user experience. Only when you have that sort of obsession over both of the customers that are actually a part of that business, well, I think you have great, great traction on the advertising side.

I have a feeling that sites like YouTube and Facebook have a long term trend in their favor with their users that’s going to force advertisers to evolve. Right now, they’re very conservative about putting ads on YouTube or Facebook because it’s really unlike any other place they’ve worked before. But I remember hearing another ad executive on a podcast with the Economist say that advertisers are always nervous about new technologies. In the end, they end up embracing it.

Will Hulu start producing their own content?

JASON KILAR: … I’ll describe a little bit of Hulu, for example, a day in the life of Hulu.

We have three customers. We have users, we have advertisers, and we have content partners. We have three customers. We don’t have one customer, we have three. And we make all of our decisions in a balanced way. And, by the way, our rallying cry as a company is to make sure that we deliver a service that users, advertisers and content owners unabashedly love, which means that the design of the service has to delight advertisers as much as it delights users, and we’re not willing to settle for less than love, to be quite frankly — to be quite frank.

And so that’s an entirely unique culture, because it means that you’re boxing your decisions, in that you have to make sure that the design of the service is very aesthetically clean for users, but also focus for advertisers. And I’m not saying it’s easy, but we constantly live that delicate balance between our three
customers and not sacrificing one out of the three or two out of the three. And that’s a huge part of our culture. If you ever stop by the office, I think you’d feel that advertiser focus. You`d feel that user focus and you’d feel that content focus…

We’re very — a big part of our culture is that we’re humble, which means that we’re very self-aware, I guess you could say. We fancy ourselves pretty good at Web site design and pretty good at technology, very good at creating advertising services that work. We happen to think that we are uniquely unqualified to create content. We don’t write scripts. We don’t produce television shows. We are uniquely unqualified to do that. So I don’t see that happening. We certainly don’t have the capability today, nor do we have the ambition to do that. I think that there’s so many talented people out there that should be doing that, as opposed to a bunch of technology geeks, which is what you’d find at Hulu.

I really like that Kilar is very willing to contain the company’s culture and core competencies. Many business failures arise when management ventures into areas where they have no real experience. They end up hiring plenty of consultants and outside expertise at a great expense and waste capital which could be allocated better by sticking within their current business.

What I also think is great is that the company seems to be employing a kind of equity ownership program among employees. This is often found in a lot of start ups, but because Hulu is this joint venture between media companies I feel like it’s pretty different. Kilar mentions that it’s one thing that sets Hulu apart from its larger owners:

JASON KILAR: If you were to take a look at the culture of Hulu and the setup of Hulu and the, you know, it couldn’t be more different than the cultures of NBC Universal and Newscorp. Now, the cultures of Newscorp.

CHARLIE ROSE: In every way.

JASON KILAR: In every way. And by that I mean that the cultures of NBC Universal and Newscorp are ideally suited to their mission, but Hulu’s mission is very different, which by saying that it necessitates a very different culture.

We all fly coach class. We eat popcorn. Like, we have cardboard boxes that hold up our monitors. We are very frugal. That is needed for the culture. And the other thing is, everybody at Hulu is an owner in Hulu. That is so different than the cultures in traditional media. But that culture.

CHARLIE ROSE: How is everybody in Hulu an owner? Meaning all the people — all your partners are owners? All the people who provide the content are owners, or?

JASON KILAR: No.

CHARLIE ROSE: No, you mean the people who work at…

JASON KILAR: My assistant is an owner, my assistant is an owner in Hulu. And that’s the way it should be. Because if we’re fortunate to create upside and to create value for Hulu, I think everybody at Hulu should participate in that upside.

In general, I think that these ownership cultures tend to create environments of hungry employees who are really committed to their product. But it’s always a bit of a risk:

CHARLIE ROSE: OK. Why did they take the risk? I mean, is it because what you are offering is down the road or in the near term offers extraordinary opportunity for income? Is it because it offers an opportunity to build something? And what is that something that they think they’re building?

JASON KILAR: I’m very sober and a realist when it comes to answering this question. And I think if you were to get to know our team, the vast majority of folks, if not all of them, are at Hulu because they see the promise of a service that they so dearly wanted themselves growing up. You know, there’s something very powerful about what Hulu can do in terms of making media available on your terms. And to me, that’s why the people are at Hulu.

There is a kicker to it, which is if we’re able to create a truly special company, there should be a financial benefit and a significant one if we’re able to create something truly special. But I think that the financials, if that’s what motivates you, you should go work on Wall Street, not work at Hulu.

I really like the bit about the frugal culture at Hulu where they fly coach and use cardboard boxes to hold up monitors. It may not be as glamorous as their counterparts in other companies, but it certainly helps keep down a lot of upfront costs and allows them to invest more in their business. Many successful startups are a result of the founders solving a problem that they themselves had or thought needed to be solved for people they knew very well. I think that’s the case here. Before Hulu, streaming media was often found on illegal sites that were often shut down within months. The sites were sometimes slow and the video quality wasn’t the best. Now, with Hulu you end up with a site that is well designed that works really well. You want to pour your hours into it and hope that they increase their library of content.

The conversation finally ended with a discussion on monetizing Twitter. At first I was pretty skeptical about Twitter, but I find myself using it more and more as a means of sharing interesting articles I find throughout the day that don’t really warrant a post on the blog. If you’re interested in that, feel free to follow me on Twitter.

CHARLIE ROSE: So is that an economic model?

JASON KILAR: Not yet. And I say — I stress yet. I can tell you that it is a business that has tremendous utility. I use it at least 20 times a day. It’s.

CHARLIE ROSE: What do you use it for?

JASON KILAR: What I do is I go to search.twitter.com and I search for the name “Hulu,” and I do that about 20 times a day, because the name “Hulu” gets written about on Twitter about 2,400 times a day right now. And by.

CHARLIE ROSE: But you can’t read 2,400 times of material, can you?

JASON KILAR: It turns out you can, as long as you look at it every 20 minutes. And so I have a BlackBerry, and I look at it every 20 minutes. And I’m not the only one. Almost everybody at Hulu looks at search.twitter.com for the word Hulu.

The reason why we do it is that it is real-time feedback on the quality of the customer experience that we’re delivering. So, we’re able to know if we’re doing something right and double down on it. We’re able to know if we misspelled a word on a Web site…

CHARLIE ROSE: And you’ll know instantly.

JASON KILAR: And we know instantly. So there are many occasions where at 11:45 at night, I’ll see a tweet about, say, a word that was misspelled, for example, on the Web site, and I’ll be able to send that to our CTO Eric, and he and I will have a conversation at 11:47 at night, and the site will be fixed by midnight. That’s a 15-minute turnaround, where without Twitter, that wasn’t
possible. It’s an amazing transparency engine.

CHARLIE ROSE: So, what will Twitter be in three years?

JASON KILAR: My prediction is that in the same way that Google is an intent revealing service that can be monetized that way, I would think that if I were at Twitter, I would focus on the search aspect of Twitter, because people are revealing intents when they do a search. That’s very valuable to marketers. So obviously I’m just commenting as sort of a sideline observer of it, but there’s
something valuable in the fact that I’m using it, quite frankly, for a lot of searches where before I did not.

CHARLIE ROSE: It is an interesting phenomenon. You’re here, we’re talking about Hulu, Twitter is on the cover of “Time” magazine. We did a show with them. I mean, it is — the level of curiosity about all of these things, whether it’s YouTube or Twitter or Hulu or so many other new Internet expressions is
extraordinary. And it’s beyond — I mean, clearly it is the province of the young. But it’s expanding in a — I find just a fascinating number of ways. Not just in terms of the ideas, but in terms of the consumers.

JASON KILAR: There’s no better time to be living, I think. I’m biased, of course, but we live in interesting times. And as a person that has this odd combination of technology passion and media passion, this is the best — this is the golden age of media, I think, because it’s leveraging technology to make it better and easier to consume. It gets back to that impulse business.

I think Kilar really nails it with where Twitter will have to go to monetize. The service’s real time search capabilities are extremely powerful for not only advertising but also things like data mining. While other media execs like Barry Diller seem to think that it is a service too difficult to monetize, I feel like it will again be a situation of the advertising model adapting to a new environment. Getting to know where people at any point in time, especially with unique locations like one particular store in NYC seems like it would have a lot of utility to an advertiser and the companies that are buying ads.

I know the interview wont give you any new investment ideas, but I think it gives you a really good take on where media is going, especially with these new technologies that seem to be disrupting the space. I thought that some of the views, especially on monetizing services like Twitter were pretty enlightening when contrasted with the more traditional media voices we heard from the Sun Valley conference a short while ago. I can’t wait for the Charlie Rose site to get updated with the link to the video and transcript so you can read the full interview yourself.

Whenever a shareholder hears of a big deal being done by a company they own, they usually get worried. Acquisitions often end up fizzling. The expected synergies never materialize and the company suffers from a drag in performance as they try to integrate acquisitions. With that in mind, how well priced is Amazon’s (NASDAQ:AMZN) acquisition of Zappos? It depends. Zappos is a private company, so it’s impossible to say with certainty what their margins and sales figures are but we can take some guesses:

The consensus appears to be that Zappos did $1.1B in sales for 2008. Now the trick is to peg an approximation of their earnings is to figure out what their margins are. This is difficult. I’ve read online that Zappos has margins of 50%, something I do not believe is true. For one thing, such margins as a retailer in the online space seem like an impossibility. Secondly, it would mean that Amazon purchased Zappos at approximately 2X earnings, which I doubt its VC-backers would stand for.

So a more sensible number that I’ve seen thrown around is $40M pre-tax earnings. Doing $40M on $1.1B of sales probably looks really bad. It means that Amazon would have bought Zappos at something like 23X earnings. A huge and unlikely valuation.

We know though, that Amazon has a pretty efficient shipping change and is a much bigger company than Zappos. It’s possible that by plugging Zappos into their shipping chain, they may be able to reduce costs. I’ve seen a figure thrown around that the average Zappos order costs $25 in shipping (due to overnight shipping plus returns). Let’s say that hypothetically, out of those $1.1 billion sales, the average order is $50. You end up with 22 million. 22 million orders at $25 an order comes out to a huge aggregate shipping cost of $550M.

Imagine taking just 10% of that $550M off, via cost savings. You end up with $55M that can be added to earnings. Earnings now becomes $95M. That means the valuation for Zappos comes out to about 10X earnings, which would be a good deal for Amazon.

That might be a risky jump to conclusions to make, but it seems like the people at Amazon would have really analyzed the potential savings that could be made on the supply chain end. I think though that there are a number of intangibles to look at here too, which add value to the deal. First, Amazon tried to move in on the footwear market with their brand Endless, it didn’t work out too well. The brand really didn’t get the kind of awareness or following that Zappos has, it simply was not very visible in the marketplace. Zappos would give Amazon a great arm in the retail-footwear market. Moreover, the Zappos brand could be leveraged to move into new areas like clothing. They have a good reputation among customers and retail clothing is an area where that would help.

Keeping Zappos as a standalone company would probably allow its management to remain entrepreneurial. This is probably a good move. A lot has been made of the management by Tony Hsieh, who many people recognize as one of the main drivers for Zappos’ success because of his continuous focus on improving customer service experiences.

He cultivates an openness with employees and the public which I really like. Take some time to read the letter he wrote to employees about the acquisition:

We plan to continue to run Zappos the way we have always run Zappos — continuing to do what we believe is best for our brand, our culture, and our business. From a practical point of view, it will be as if we are switching out our current shareholders and board of directors for a new one, even though the technical legal structure may be different…

We are excited about doing this for 3 main reasons:

1) We think that there is a huge opportunity for us to really accelerate the growth of the Zappos brand and culture, and we believe that Amazon is the best partner to help us get there faster.

2) Amazon supports us in continuing to grow our vision as an independent entity, under the Zappos brand and with our unique culture.

3) We want to align ourselves with a shareholder and partner that thinks really long term (like we do at Zappos), as well as do what’s in the best interest of our existing shareholders and investors.

If the above is true, I think there’s potential for this working out really well. Amazon is acquiring a company is run by entrepreneurs who really love their business and are willing to pour their heart into it. That’s basically the blueprint to many of Berkshire Hathaway’s most successful acquisitions. If you wanted to learn even more about Tony Hsieh, I’d direct you to this cool presentation at SXSW 2009:

Also, the letter also includes this great video with Jeff Bezos:

Both Bezos and Hsieh appear to be really sharp operators in the retail industry. Investors often shy away from retail because it’s so cutthroat and your customer can walk in and steal your business model. So whenever I come across people in that business, who appear to be executing really well I take notice and study how they run their businesses. Bezos and Hsieh are both two businessmen worthy of such attention.

Further reading:
The Zappos Way of Managing (Inc.com)
Charlie Rose interviews Jeff Bezos (CharlieRose.com)