2019 Mid-Year Portfolio Review

Not quite mid-year, but given the recent market volatility, I've been able to buy into a few companies that I've been monitoring for a while, and wanted to provide a quick summary of my positions and rationale. I think it's also important to chronicle both the ups and the downs as they happen, to reduce any hindsight biases.

Nokia (NOK)

Nothing has really materially changed here, although the stock is down 15% YTD. They have had some revenue recognition headwinds in Q1, and investors have been impatient with the pace of 5G revenue growth. Nokia has also faced some difficulty with initial 5G rollouts in South Korea, but this seems mostly due to inconsistencies in the developing 5G ecosystem, and the comment on this article by Nokia's CMO, Barry French, is worth reading.

More importantly: they continue to win 5G contracts; their major competitor, Huawei, faces increasingly strong (and perhaps existential) headwinds; and management continues to maintain full year guidance, which they have never failed to hit since Rajeev Suri became CEO in 2014.

https://www.fatfireinvestor.com/nokia-models-precision-and-accuracy/

https://www.fatfireinvestor.com/nok-thoughts-on-q4-2018-earnings/

XP Power (XPP.L)

No new updates here. This is a fairly thinly traded stock and they only report twice a year. But they have maintained full-year guidance, despite notable pressures in the semi-conductor manufacturing industry.

https://www.fatfireinvestor.com/xp-xp-power/

Micron (MU)

Long-term thesis is unchanged. The biggest threat in my mind is competition from Chinese DRAM manufacturers, but this seems like it has been delayed due to trade tensions, falling DRAM prices that make the economics less favorable for new entrants, and sanctions.

Given the short term noise with trade tensions, I think it's also important to note that: MU's exposure to China not as large as commonly reported, because they break out geographic revenue by a ship-to basis (=> 57% China exposure) rather than an end-customer basis (=> 20% China exposure); they have ways to shift production such that products getting manufactured in China are being sold to markets out of the USA; and, since DRAM is a commodity with relatively fixed supply and demand, even if South Korean manufacturers end up increasing Chinese market share, this will open up more shipments for MU elsewhere in the world.

https://www.fatfireinvestor.com/micron-fear-risk-and-cyclicality/

Baidu (BIDU)

Baidu recently had a "terrible" earnings report that caused their stock to fall by 15%, even though revenue grew 21% YoY (excluding divested businesses). The reason for the pessimism was poor Q2 guidance (basically, flat YoY).

The main fears are that: 1) their core search revenue growth is plateauing as more and more users turn to closed-app ecosystems and 2) costs are increasing as they invest in other long term opportunities like Cloud, AI, Autonomous Driving and Video.

There is also a lot of hype about how fast growing short form video and news feeds apps are stealing advertiser revenue share, but I'm going to go out on a limb and predict that advertisements placed on dancing cat videos and viral news articles are less relevant than ones that are contextually / search targeted, and eventually the balance will shift as China's online advertising market matures, and advertisers demand better performance.

There is a more detailed analysis of Baidu here:

https://www.fatfireinvestor.com/bidu-chinas-google/

But, more roughly:

  • Baidu's Current Market Cap: $45B USD
  • Net Cash: $12B
  • Liquid investments in public securities (CTrip, China Unicom): $5B
  • Controlling equity stake in IQIYI: $7.8B
  • Illiquid equity stake in Didi Chuxing: $750MM - $1.5B (probably on the lower end, based on investor reception to Uber and Lyft)

This values the "core" search business, which generated ~$3.5B in operating income last year, at ~$19B, an almost absurd multiple unless you think that Baidu will completely go out of business and people will stop using search entirely (despite the fact that management is still projecting growth, albeit modest, during historically tough macroeconomic times in China).

You're also getting the following businesses for "free":

  • Voice Assistant AI (DuerOS) - Installed on 275MM devices and handling 2.37B voice queries per month.
  • Apollo / Autonomous Driving - Leader in autonomous driving miles in China. Probably worth at least $1B, based on private market valuations.
  • Baidu Cloud - On pace for $1B USD in revenue this year, and growing 100%+ YoY. Long term operating margins should be comparable to AWS (20%+), especially considering the services are higher up the value chain.

Fiat Chrysler Automobiles (FCAU)

Seems significantly undervalued even assuming a "worst case" 30% decline in automobile sales due to a near-term global recession (which may not even come).

Strong insider / family ownership, decreased leverage that should help with weathering any downturn, and experienced management team (even with Sergio Marchionne gone).

There has been a lot of skepticism about whether or not they will be able to achieve their long-term financial plan, which might explain the discount to fair value. But: management incentives are set in such a way that the must believe they can hit their long term goals, if they want to be compensated; they seem to trade at a large discount even if you assume they wildly miss expectations; and initial reviews of the Jeep Gladiator and Dodge Ram have been highly favorable.

Credit Suisse (CS)

Swiss-bank in the midst of a 3-year turnaround, trading at a 25% discount to tangible book value despite the fact that they have significantly shifted most of their revenue from volatile Investment Banking to the more stable Banking and Wealth Management businesses. Also trades at a 25% discount based on long term earnings potential from the Banking and Wealth Management businesses alone.

They are targeting growth from high net worth individuals, and there appear to be plenty of growth opportunities in both China and Saudi Arabia, where they have recently opened up branches and obtained licenses. They also have a strong brand (Swiss banking), combined with the advantage of Swiss neutrality and relative predictability in a world increasingly beset by tensions between China and the US, and uncertainty in the Eurozone / UK.

Ceragon Networks (CRNT)

Niche player in wireless backhaul. Very broadly, as the 5G rollout occurs, the increased bandwidth requirements will require greater backhaul capability and a larger number of base-stations. Most of this need will be met by fiber, but wireless backhaul will fill an important need in areas where laying fiber is not an option, due to either cost or geographical difficulty.

Guidance for revenue is flat. A large portion of their revenue is from India, which is a substantial risk, but management is also not factoring in 5-6 large contracts in the pipeline in other geographies. If even a few of these are realized in the next few years, the impact could materially increase revenue. But even if they aren't, and they merely maintain the status quo, they still seem undervalued on a long term earnings power / cash flow basis.

Closed Positions

Exited positions in both Marvell (MRVL) and Despegar (DESP). They are both strong companies and I continue to think they will have favorable business prospects, but their valuations were stretching even my most long term, optimistic expectations.

Concluding Thoughts

Most of the stocks in this list are unloved for various reasons, but I'm comfortable owning them because they all have relatively strong brands, shareholder aligned management incentives, and straightforward, defensible business models that should continue to generate cash long-term.

A lot of them face near-term headwinds or cyclical fears, but by even an extremely pessimistic reading of their future prospects, they still seem significantly undervalued.

More generally, many other stocks appear priced for perfection: trade war will end, interest rates will be cut, inflation will stay low, and earnings will increase indefinitely. Expectations are high, but if merely one thing goes wrong, these stocks will likely plummet. In contrast, if anything goes right in the companies above, the stocks should appreciate considerably; much of the bad news has already been factored in.

That's not to say that there isn't considerable risk; it's impossible to say where the companies will bottom out, and there will probably be some embarrassing misses and unpleasant surprises. But, on balance, I'd rather own stocks that others avoid, and the tradeoff between downside risk / upside reward for the portfolio seems favorable going forward.

Disclaimer: I am long XPP.L, NOK, FCAU, CS, CRNT, BIDU, MU.

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