Q1 2020 Letter

It goes without saying that a lot’s happened these last few months. Markets are volatile machines. COVID-19 rears its ugly head in the US. There’s a lot to worry about. First and foremost, I hope this letter finds you healthy and safe. If anything, this lockdown has shown us what really matters: family, faith (if you partake) and a fridge full of food. 

I didn’t write a Q4 2019 letter — as the transition between paper account and real money Fund took precedence. That being said, we returned roughly 20% in 2019 — lagging the S&P by around 4%. 

Now, onto this year. The real money Fund returned -10% in Q1 2020. This compares to -20.62% in the S&P 500 and -30.69% in the Russell 2000. While we’re never satisfied with negative returns, we’ll take a 10% loss versus a 20% loss. Remember, it’s survival that matters in this game. If we work very hard on not losing money, the upside will take care of itself. I like to compare investing to poker. And as long as we have chips on the table, we’re in the game. We give ourselves a chance.

During the first quarter, we established Rockvue Capital, L.P. — the Fund vehicle. We also created Annapolis Capital Management, LLC — the Fund’s General Partner — which I run as the managing member. 

Then the banks closed. This delayed the opening of the actual Fund until further notice. A few of you have expressed interest in investing in the Fund. We’re extremely humbled and excited. You have no idea how humbling and honoring it is to have a chance to steward and (hopefully!) grow your hard-earned capital.

We look forward to announcing the Fund’s official start date. The Fund will close at $50M and is restricted to 35 non-accredited investors. 

Doing Things Our Way

Traditional value investing suggests buying cheap companies and holding them through thick and thin. In fact, many value investors shun the idea of using stop-loss orders to protect downside risk. While we acknowledge their concerns and understand their point of view, we do things our way. 

We have one job at Rockvue Capital: generate outsized absolute returns compared to a low-cost S&P 500 index. 

We do that by finding, studying and investing in great companies at cheap prices. There’s a few things that make companies “great”: 

• Skilled management team
• Essential product
• High switching costs 
• Little-to-no debt
• High insider ownership
• Leader in niche industry
• Business generates high returns on capital

The list goes on. 

Yet Mr. Market doesn’t care if these companies are great (or cheap). The first quarter revealed that even great companies at cheap prices sell off in a liquidation event. That’s why Rockvue Capital adds another layer to its investment process: technicals. 

Sitting On Our Hands

The Fund started reducing its equity exposure around February 24th. Since then, we’ve stayed roughly 70%-75% in cash. We’ve made a few investments, which we’ll discuss in the following pages. But we’re content with waiting on the sidelines for now. 

We last saw this type of volatility in 2008-2009 during the Great Financial Crisis. Using that period as a proxy, one can argue that we’re not close to a technical “bottom” in equity markets. In fact, individual stocks are showing signs of that thesis. Many stocks are testing their previous lows, looking for price support and a base. If we get strong bases, we could see a quick turnaround. 

But what happens if prices fall through their recent lows? How much further do equities have to fall? Quite far. We haven’t seen the complete capitulation that we saw in 2009. High-flying blue-chip stocks (think Mastercard, Visa, etc.) trade around 30x current earnings. These aren’t “crazy cheap” numbers. 

That being said, our watchlist of potential investments has never been longer.

We’re excited to put our capital to work when the time comes. For now, we’re happy holding cash while we build our list of potential investments. 

A “No-Limits” Investment Approach

Our watchlist is a testament to our no-limits investment philosophy. The list is diverse as it is long. Some of the companies include: 

• Micro-cap Canadian casino business
• Micro-cap glass manufacturer
• Large-cap banking/financing business
• Large-cap Americana-style restaurant
• Small-cap South African telematics company
• Micro-cap Polish industrial company
• Mid-cap Swedish gaming company

Rockvue Capital looks, acts and feels nothing like any stock index. That’s on purpose. Our goal is positively outsized returns over decades. To accomplish this, we can’t look like a broad index. We’ll own fewer companies than an index. We’ll own smaller companies than an index. We’ll own more illiquid companies than an index. It’s in our DNA. 

We’ve spent hours thinking of a motto for Rockvue Capital. It’s a rough draft version, but we love it: 

We invest where others won’t, to generate returns others can’t.

If we do our job well, work hard and have a bit of luck, we’ll stand true to that statement. 

Portfolio Update

The Fund had twelve investments at the end of Q1 with a substantial cash position. We made two new investments and exited one of our longer holdings at a substantial loss. Let’s discuss the loss first.

We sold our remaining stake in Target Hospitality around $4.50. Target was a substantial drag on the portfolio since initiating a position in 2019. In short, we made two mistakes with TH. As mentioned in previous letters, we bought too much, too soon. We compounded this error by investing in a commodity-dependent company with questionable terminal value (modular homes). 

We’ve learned from our mistakes and paid Mr. Market his tuition bill. As Ray Dalio says, mistakes offer gems of knowledge. As investors we make a choice. Do we accept these mistakes and learn from them? Or do we ignore our mistakes, bury our head in the sand and pretend they didn’t happen? 

We chose the former. We’ll continue to learn from our mistakes, both of commission (buying what we shouldn’t have) and omission (not buying what we should’ve). 

Attached at the end of the letter is a discussion on our two investments: Nintendo and Sony. 

Being Certain of Uncertainty 

We have no idea what the next three months or three years will look like. Many pundits (much smarter than myself) seem to think equity markets will return 1-3%/year for the next five years. But again, nobody knows what the future will bring. 

What we do know is that we don’t know. And that’s comforting. Our job at Rockvue Capital is to grow and protect your capital. We do that by investing in fantastic businesses at crazy cheap prices. Then we protect our downside by buying on the lows, cutting our losses quickly if the stock makes a new low. Waiting for even better buying opportunities. 

Our job isn’t to forecast the next five years of returns for the S&P 500. Nor is it to guess where the US economy will be in five years. Bottoms-up, fundamental analysis is our bread and butter. 

We’ve never been more excited about our investment opportunities. 

We look forward to reporting to you next quarter.

Appendix

The Fund added two new positions in Q1: Nintendo (NTDOY) and Sony. Inc. (SNE). Both companies’ products are well-known, global and command high brand power. So why did we buy them? 

Nintendo: From Console Cycle to Subscription Model

Nintendo is a perfect example of a great business trading at a cheap price. The company has ~$9/share in net cash and trades for 10x 2019 EV/EBITDA. On a multiple basis alone, the company’s cheaper than its peers. For example, Electronic Arts (EA) trades at 16x EBITDA. You can buy Activision (ATVI) for 13x EBITDA. 

Here’s the kicker. Those other video game companies don’t have what NTDOY has: Intellectual Property (IP). 

NTDOY has some of the most popular video game brands of all time. 20 out of the top-25 best-selling games of all time are Nintendo games. Think about that. That’s market domination. 

Why is Mr. Market offering this opportunity? Our hypothesis: Mr. Market thinks NTDOY will be subject to the traditional boom-bust cycle of console gaming. 

The traditional video game cycle isn’t attractive. But NTDOY’s betting on three business segments: traditional hardware, online subscriptions and mobile gaming. 

• Traditional Hardware

Their traditional hardware business is growing, thanks in large part to the Nintendo Switch. The Switch was the most searched item on Amazon’s Prime Day last year. NTDOY sold over 52 million Switches in 2019, smashing its previous device sales records. But the real bread and butter isn’t in the hardware sales. It’s what you can do with the hardware sales. 

• Online Subscriptions

In 2018 NTDOY released its online subscription gaming service. Subscriptions ranged from $3.99 (1-month membership) to $19.99 (1-year). The subscription offered users many classic Nintendo games. And like Netflix, new games were promised each month. How popular is Nintendo’s new online service? 

According to dailyesports.gg, the company surpassed 15 million paid subscribers in January of 2020. They started the subscription in 2018. That’s impressive growth. Around 27% of Nintendo Switch subscribe — so there’s plenty of room for growth. 

• Mobile Gaming

NTDOY’s biggest market isn’t hardware sales, it’s mobile gaming. Almost everyone has a smartphone. We all remember Pokemon Go. Some of my friends still play the game today. Pokemon Go generated over $2B in sales. Granted, only 13% of that revenue went to NTDOY (due to third party developers, etc.). But they learned a lesson: mobile gaming is very profitable. 

As an example, NTDOY released Fire Emblem Heroes, a mobile-only game. This game has done $500M in sales since inception. Imagine how profitable Mario Kart will be. 

Valuation: Cheap Price For Great Business

We believe Mr. Market’s focusing on the wrong metrics: hardware sales. The future of NTDOY will look much different. It will center around recurring-revenue subscriptions and smartphone games. These are higher margin businesses not subject to the traditional boom-bust video game cycles. 

Luckily for us. Mr. Market hasn’t realized this alternative reality. We bought our stake at $41/share. At this price, we’re getting nearly all of its mobile phone growth for free. The company has $8.7B in net cash with no debt on the balance sheet. Management’s buying back their stock. It checks all our boxes. 

At $41/share we paid roughly 7x our 2023 estimate of EBITDA. That gives us a 13% yield if we’re right. Our downside is protected by the company’s balance sheet, strong IP and the massive esports industry tailwind. 

Sony, Inc. (SNE): Get Four Businesses For Free

Sony Entertainment (SNE) is the global leader in electronic software, hardware, instruments and other electronic equipment. With nearly $80B in annual sales, few (if any) companies can compete with SNE on a global scale. Despite its tremendous brand power, strong market leadership and worldwide recognition, you can buy the company for less than 8x EBITDA. 

Like all companies, there’s no doubt SNE will feel the impact of COVID-19 in the upcoming quarters. But the stock is so cheap that even if we assume worst-case-scenario over the next two years, we’ll be fine. In fact, if we assume 08-09 levels of revenue reduction and margin compression, with an even slow return to “normal” over the next five years, there’s still a discount at current prices. 

Buy Two, Get Four Free

Mr. Market’s offering an interesting pitch. At the current price, you can buy SNE’s Imaging & Sensing Solutions business and their Game & Network Services business for a combined 13.5x Operating Income. 

In other words, you get six operating segments for the price of two. Not a bad deal. And we know the other four segments are worth something. They all generate operating profits. That’s another $3B in operating income you get for free at the current share price. 

We know they’re worth more than zero. Let’s dive our freebie segments. 

Sony Music: High Growth, Strong Cash Flow ($2.1B 2018 Operating Income)

SNE’s Music segment has two parts:

1. Sony Music Entertainment
2. Sony/ATV Music Publishing

Both businesses are growing at a rapid clip. The Entertainment business has shown a 25% CAGR in operating income since 2016. They’ve also grown margins over 650bps since 2016. 

Streaming leads the way for the entertainment business. Accounting for 47% of total revenue, streaming generated $9B last year. They did this by increasing paid subscriptions 33% and video 22%. 

Let’s shift to their Publishing business. This segment’s grown around 6% annually since 2013. Nothing crazy, but not bad. SNE’s publishing segment bought the remaining interest in EMI Music Publishing during 2019. The deal gave SNE 2.1M copyrights and a high margin, recurring revenue business with stable cash flows.  

EMI comes with some of music’s biggest stars: Drake, Stevie Wonder, Queen, Pharrell and Pink (to name a few). 

Combined, SNE’s publishing business is now the number one publisher in the world. It’s the leader in revenue, US radio airplay and UK singles market. Total domination. 

And again, you’re getting this business for free. Wild. 

Onto the motion pictures business. 

Sony Motion Pictures: Growing IP with Desirable Content ($489M 2018 Operating Income)

SNE’s Motion Pictures segment generated $489M in operating income off $8.87B in revenues (5.5% margin). I’m not concerned with the motion pictures business. They generate around $500M in annual operating income. But that’ll be a bumpy $500M. Depending on when certain films and shows hit the wire, we’ll see wild gyrations in revenues and earnings. 

Over time, SNE Motion Pictures should grow its IP and original content. This will increase in value as the demand for content increases with the number of streaming services / bundled packages. I don’t think they’ll monetize their IP like Disney or Nintendo, but we don’t need them to in order to win on this investment. 

Remember, we’re getting this business for free. 

Electronic Products & Solutions: Market Leader with Strong Brand Power

SNE’s EP&S segment operates a collection of smaller businesses: 

• TV
• Video & Sound
• Digital Imaging
• Medical
• Smartphone
• Solutions

Together these businesses generated $690M in operating income on $21B in revenues. SNE remains top-five in LCD TV sales, number five in unit share and #3 in revenue share as of 2018. 

The video and sound business includes headphones, sound bars, wireless speakers and other home video equipment. That segment alone generated $3.25B in revenues. 

Digital Imaging and Still Video Camera accounted for over 50% of the $6B in sales from the IP&S segment. Most of those revenues come from either North America, Europe or Japan. As of last year, SNE retained 24% market share in still cameras and 29% market share in video cameras. 

Financial Services: $1.4B Portfolio For Free

SNE also sports a financial services business. This business includes life and non-life insurance operations through its Japanese insurance subsidiaries. It also offers banking operations through a Japanese internet-based banking subsidiary.

This segment generated $1.45B in operating income last year. Once again, you’re getting this for free. 

Valuation: Worst Case = Discount

In our base case valuation, we’re assuming a few worst-case scenarios:

• Revenue declines of -20%, -15% and -5% over the next three years

And 

• Slashed EBITDA margins of 7%, 1% and -5% over the next three years

I know it sounds crazy. But we’re in crazy times. The GFC is the only shred of reliable proxy we have in dealing with the next few years. If SNE’s cheap assuming the above criteria, anything less severe is icing on the cake. 

In the above scenario, we end 2024 with $45.4B in revenues, $3.17B in EBITDA and over $1B in after-tax income. Due to the loss-laden next three years, we end 2024 with an EV of -$11B. We add back SNE’s cash and any short/long-term investments and get $122B in Enterprise Value. Subtract out debt, another $16.5B, and we have around $94B in shareholder equity ($76/share). 

Remember, we’re assuming 2008-2009 type compressions in revenues and margins. Anything short of that is an added bonus. 

Risks

SNE faces a few headline risks:

1. Failure to unlock value via spin-offs / restructurings
2. Gaming cycle & PS5 flop
3. Smartphone market fails to grow/reduce cash burn