Frankly Speaking

Spitznagel: The Austrians And The Swan – Birds Of A Different Feather

Frank Voisin — Fri, 25 May 2012 05:00:20 +0000

Mark Spitznagel, founder of Universa Investments and one of Nassim Taleb’s collaborators, recently published this white paper clarifying the notion of black swans (come to the site if you can’t see this):

Talk to Frank about this white paper

NYTimes: Disclosure by Short-Sellers Would Improve Market Clarity

Frank Voisin — Fri, 25 May 2012 02:27:45 +0000

I couldn’t agree more with this NYTimes article on short seller transparency:

The questions were fairly innocuous and appeared to be probing the breakdown between distributors and the actual buyers of Herbalife products. Yet soon after Mr. Einhorn’s questions, the company’s shares tumbled. Investors were assuming he knew something and had placed a big short bet.

Mr. Einhorn, however, did not and has not disclosed whether his firm has any position whatsoever in the stock. Does that make sense when every analyst has to disclose such information?

Such wild gyrations of stocks based on the barest mention by short-sellers revive the debate on rules requiring disclosures of big short positions.

Short-selling provides significant market benefits, including adding liquidity and incentives for price discovery as investors seek to profit from public company problems. The short-seller James Chanos was instrumental in helping point to possible fraud at Enron.

Short-sellers have a right to try to talk a stock down, just as much as other investors can try to talk a stock up. …

This is a different world than long investing, speculating that stocks will go up. Investors buying stocks are required to disclose when they have a 5 percent or more position in a publicly traded company and funds must disclose any long positions on a quarterly basis to the S.E.C.

But these requirements do not apply to short-sellers. Instead, the market is left to speculate. But even more so in the case of shorting than long positions, disclosure seems to be necessary to prevent manipulation as well as to ensure that the market functions efficiently and can properly assess not only big short bets but cheap talk. Markets, unfortunately, thrive on fear, and such disclosure would tamp this down.

Read the rest here. What do you think of short seller transparency?

Author Disclosure: None

Talk to Frank about Short Sellers

Nassim Taleb and David Cameron: Building a “Black Swan-Robust” Society

Frank Voisin — Thu, 24 May 2012 10:00:46 +0000

Here’s Nassim Taleb, author of Fooled by Randomness and The Black Swan, and current Prime Minister of the United Kingdom, David Cameron, discussing what measures governments should take in order to create a more ”Black Swan-Robust” society. Overall, I was impressed with Cameron’s questions and walked away thinking he has a handle on this stuff better than most politicians.

Author Disclosure: None

Talk to Frank about Nassim Taleb

Beating the Business Cycle: How to Predict and Profit from Turning Points in the Economy

Frank Voisin — Wed, 23 May 2012 10:00:37 +0000

Beating the Business Cycle:
How to Predict and Profit from Turning Points in the Economy

By Lakshman Achuthan and Anirvan Banerji

Today I am reviewing Beating the Business Cycle: How to Predict and Profit from Turning Points in the Economy. Read my other book reviews here.

Lakshman Achuthan and Anirvan Banerji are co-founders of the Economic Cycle Research Institute, or ECRI, which I have discussed on this site several times. The firm has a rich history of accurately predicting recessions and recoveries and I have enjoyed reading Achuthan’s views on the current state of the economy, so I was excited to learn that this book existed, even if it is a bit out of date (published in 2004)

The book is ostensibly about predicting the turning points in the business cycle so as to help guide business and investment decisions. In the introduction, the authors write “It really is possible to predict recessions. And we will show you how, so that you will no longer be at the mercy of economic cycles.” This is a tall order and I’ve been leery of books making such big promises. However, I figured there would be some useful pointers that I could use in improving the utility of my Economic Indicators Dashboard, as the authors explicitly state:

In Beating the Business Cycle, we share this information so that you, too, can create your own customized “economic dashboard” that will help steer your future financial decisions in the right direction before you find yourself plunging into the abyss.

Let me be clear from the start, this book does not teach you how to predict recessions, nor does it provide much use in creating a custom economic dashboard. Rather, it is more of a marketing tool for ECRI and its services. Is that a bad thing? Not necessarily. If you can get past the boredom of the authors’ constant examples of how successfully they guided this client or how accurately they called that turning point (in the face of searing skepticism I might add), and if you can accept that the book does not actually achieve what it claims, there are some limited instances where this book would be worthwhile for some readers.

For example, there is a good introductory explanation of the business cycle and the often confused growth rate cycle, as well as the use of indicators and how the various categories (lagging, coincident, and leading) of indicators work. There are many examples strewn about the book of different indicators and general discussion of how they have performed in certain situations in the past. Unfortunately, this is done haphazardly, whereas the book would have been greatly improved had the authors taken a systematic approach to discussing different indicators and their predictive power historically exist.

Another thing the book might be useful for is sparking interesting in digging deeper into economic indicators (though, if you pick up the book presumably you are already quite interested). Before reading the book, I would have said a recession begins when there are two consecutive quarters of negative GDP growth. Unfortunately this is a lagging and imperfect indicator, so the authors go back to the basics to show first what a recession fundamentally is:

[D]uring a typical recession, companies fire employees, incomes fall, spending goes down, and output declines. By examining the historical record, we know that, during recessions, these four factors—employment, income, output, and sales—tend to decline together.

Unfortunately, perfect knowledge of the comovement of these factors would still only be a coincident indicator and we want leading indicators. The authors give a few very rough examples of leading indicators (“sensitive commodity prices”) and are quick to point out that there are many pitfalls. Complicating things further, rather than looking at these variables directly, we often want to look at rate of change in these variables. Oh, and the different variables all have varying predictive power and it is easy to be misled. All of this is well and highly complicated, so why don’t you just let ECRI do the heavy lifting and pay for their services? Such is how the book carries on. You keep reading with the expectation that in just a few more pages they will provide a clearer outline of the different indicators and their predictive power, but alas the conclusion is this:

So what is our secret? What are the components of the leading indexes we have created, and why do they work when others fail? Unfortunately, there is no short list of indicators that will work for every circumstance. And no single indicator has proven to be the Holy Grail of economic forecasting. Instead, we regularly monitor hundreds of indicators that have proven their worth over time. We have found that different indicators take turns at being accurate predictors. Trying to anticipate which one is going to accurately forecast the next turn in the economy is a fool’s errand. But, over time, we have identified a limited number of drivers of the economic cycle that, taken together, can show where the economy is headed. While it is impossible for us to know which individual driver will take the lead at the next turning point, together they can detect early signs of an upcoming turn in the economy with near certainty.

So “ultimately there is no short list” but they “have identified a limited number” (read: short list) of drivers that can “show where the economy is headed” but they won’t share it despite that being precisely what the book claims it does.

Ok, I can’t say I was surprised by the book’s inability to turn me into a business cycle predictor, but how about helping the reader create his own “customized economic dashboard?” Well, this boils down to – I swear I am not making this up – going to ECRI’s website on a regular basis and reviewing the Weekly Leading Index (WLI) and the Future Inflation Gauge (FIG)! So, not really “your own customized economic dashboard” after all.

Should you buy this book? Probably not. I was quite disappointed that Achuthan, who I respect and have found to write logical and valuable pieces on the economy, would publish something as superficial as this.

Ok, on a side note, this is the third somewhat negative book review I’ve done in a row. I am starting to feel a lot like Charlie Brown with Lucy and the football; I don’t see why authors feel compelled to market their books as something different than they are, only to disappoint readers and ruin their own reputations. It seems short-sighted. Anyways, I am hunting for good books. If you have any book recommendations (or if you’d like to write one of these reviews) let me know. I’ve got a few promising books in the hopper, so hopefully the next one will be positive!

If you’ve read Beating the Business Cycle, leave your thoughts below.

Buy This Book Here

Author Disclosure: None

Talk to Frank about this Book

Nassim Taleb on JP Morgan’s “London Whale”

Frank Voisin — Tue, 22 May 2012 10:00:06 +0000

Here’s a new BBC interview with Nassim Nicholas Taleb, author of Fooled by Randomness and The Black Swan, on the JP Morgan trading loss:

Author Disclosure: None

Talk to Frank about Nassim Taleb

Barron’s: Ray Dalio’s World

Frank Voisin — Tue, 22 May 2012 08:00:37 +0000

Over the weekend Barron’s ran a profile of Ray Dalio, founder of Bridgewater Associates, whose views on the macroeconomy are second to none:

It’s hard to imagine anyone navigating the rough seas of the past decade more ably than Ray Dalio, master and commander of money-management firm Bridgewater Associates, which oversees $120 billion for a roster of global clients that include foreign governments, pension funds and endowments.

The Westport, Conn.-based company is the world’s largest hedge-fund firm and one of just a handful of players to place more than one fund on Barron’s annual Top 100 Hedge Funds ranking. This year Bridgewater’s flagship Pure Alpha II and its All Weather @12% global macro funds both make the list, (see below for list.). Pure Alpha has tallied a three-year average return of 22.75% while All Weather gained 17.24% on that basis. BarclayHedge’s index of hedge funds returned 9.05% a year in that time; the Standard & Poor’s 500 gained 14.11% annually.

The Bridgewater funds make strategic bets on commodities, currencies, bonds, and equities around the world based on analysis of valuations and macroeconomic trends. Dalio, who brings an unusually broad and deep perspective to investing, recently shared his latest views with us.

Barron’s:You’ve called the current phase of the U.S. deleveraging experience “beautiful.” Explain that, please.

Dalio: Deleveragings occur in a mechanical way that is important to understand. There are three ways to deleverage. We hear a lot about austerity. In other words, pull in your belt, spend less, and reduce debt. But austerity causes less spending and, because when you spend less, somebody earns less, it causes the contraction to feed on itself. Austerity causes more problems. It is deflationary and it is negative for growth.

Restructuring the debt means creditors get paid less or get paid over a longer time frame or at a lower interest rate; somehow a contract is broken in a way that reduces debt. But debt restructurings also are deflationary and negative for growth. One man’s debts are another man’s assets, and when debts are written down to relieve the debtor of the burden, it has a negative effect on wealth. That causes credit to decline.

Printing money typically happens when interest rates are close to zero, because you can’t lower interest rates any more. Central banks create money, essentially, and buy the assets that put money in the system for a quantitative easing or debt monetization. Unlike the first two options, this is an inflationary action and stimulative to the economy.

How is any of this “beautiful?”

A beautiful deleveraging balances the three options. In other words, there is a certain amount of austerity, there is a certain amount of debt restructuring, and there is a certain amount of printing of money. When done in the right mix, it isn’t dramatic. It doesn’t produce too much deflation or too much depression. There is slow growth, but it is positive slow growth. At the same time, ratios of debt-to-incomes go down. That’s a beautiful deleveraging.

We’re in a phase now in the U.S. which is very much like the 1933-37 period, in which there is positive growth around a slow-growth trend. The Federal Reserve will do another quantitative easing if the economy turns down again, for the purpose of alleviating debt and putting money into the hands of people.

We will also need fiscal stimulation by the government, which of course, is very classic. Governments have to spend more when sales and tax revenue go down and as unemployment and other social benefits kick in and there is a redistribution of wealth. That’s why there is going to be more taxation on the wealthy and more social tension. A deleveraging is not an easy time. But when you are approaching balance again, that’s a good thing.

Read the rest here.

Author Disclosure: None

Talk to Frank about Ray Dalio

SanDisk Corp: Unattractive Industry Economics and Unwanted Behaviour ($SNDK, $AAPL)

Frank Voisin — Mon, 21 May 2012 10:00:26 +0000

SanDisk Corporation (NASDAQ: SNDK) is a global leader in flash memory storage products. The company sells a variety of such items, including USB flash drives and other portable media (e.g. SD, MicroSD, Compact Flash), embedded memory for mobile phones and tablets as well as a range of high end solid state drives (SSD) used in laptops, desktop PCs and network servers. The company pioneered (solely or in partnership with other market leaders) many of these technologies and has a sizable patent portfolio that has generated $1.15 billion in licensing revenue over the last three years (covering much of the $1.35 billion the company spent on R&D over the period!).

There are a lot of things to like about SNDK. Perhaps most notable is its solid capital structure with $3.84 billion in net cash which comprises 45% of its market cap, resulting in an EV of about $5 billion. On this basis, the company has generated average free cash flow over the last three years of around $800 million, for a yield greater than 16%. Furthermore, the company has experienced significant growth, with 2011 revenues 45% higher than five years prior (7.7% CAGR: not bad for a recession!).

At the time of writing, the company’s stock is down 26% YTD as a result of a weak first quarter and poor forecast for the second quarter. When I see a company with solid historical performance collapse in price as a result of one bad quarter, I investigate to see whether this is a temporary anomaly that might present a good value opportunity.

So what happened in Q1? Checking the company’s earnings press release, we see a slight decline in revenues and pretty significant gross margin contraction. The president and CEO had this to say on the conference call:

We now believe the industry experienced an imbalance between supply and demand in the first quarter, and we believe this imbalance is likely to continue through the second quarter of 2012. Industry demand has been weaker than we had expected, and we believe supplies have increased more than we had estimated at the beginning of the year. This led to greater-than-expected price decline, particularly in the second half of the first quarter, impacting our revenue and gross margin. …

For SanDisk, our first quarter results were impacted by 2 key factors: greater-than-expected price decline; and slower-than-expected demand for mobile cards from certain OEM customers with whom we have high shares.

Let’s take the second factor first. SNDK has little to no exposure to Apple (NASDAQ: AAPL), and Samsung (the largest mobile manufacturer) only accounts for 10% of SNDK’s sales. So the bulk of SNDK’s revenues from mobile OEMs are from players outside the top tier. Industry dynamics have been forcing the (distant) second tier to cut prices dramatically in order to compete with the top tier. The result is that these manufacturers are no longer bundling microSD cards with their phones, which means consumers then have to buy cards on their own. These sales would logically be higher than the bulk sales to OEMs, but not all of these purchases will buy microSD cards and many may buy from SNDK’s competitors (from my check of various retailer websites, SNDK appeared to be priced significantly higher than its competitors). Note also that SNDK executives stressed in the conference call that the company has several products being tested by the top OEMs (read: AAPL) for implementation later this year which should help SNDK’s mobile sales.

The bigger issue is the first: a “greater-than-expected price decline.” In some industries, this is the result of a one-time phenomenon that leads to short-term pain as companies digest oversupply and atone for overly optimistic past projections. Unfortunately, this is not one of those industries. You see, SNDK and its competitors are trapped on a rapidly moving treadmill that requires all parties to bring their costs down at an ever increasing rate in order to maintain profitability (hence the “expected” decline). From the company’s 10-k:

We believe the markets for flash storage are generally price elastic… In order to profitably capitalize on this price elasticity, we must reduce our cost per gigabyte at a rate similar to the decrease in selling price per gigabyte, while at the same time increasing the average capacity and/or the number of product units enough to offset price declines. We continually seek to achieve these cost reductions through technology improvements, primarily by increasing the amount of memory stored in a given area of silicon.

On one hand, the competition to bring prices down is good in that it will drive the transition from traditional HDDs to SSDs and open up the industry to a much larger audience. On the other hand, a bet on SNDK (or any of its competitors) is really a bet on its ability to reduce its costs per gigabyte faster than the price decline per gigabyte. In a perfectly competitive environment, the company with the lowest marginal production cost sets the price and drives down the profitability of all the other players (before we rush to assume perfect competition, note that industry participants are subject to a number of ongoing class action lawsuits alleging price fixing – see Note 16. Litigation). So SNDK is constantly striving to have a lower cost base than its competitors, which will allow it to set the price.

There are a few things to be worried about here. First, whenever industry competition is based largely on price there is a significant risk created as marginal competitors are driven from the industry. These competitors dump their products and try all sorts of wild and unpredictable things as they attempt to stay alive, often upsetting (even if just for a short time) industry economics.

Second, the effort to reduce costs is expensive in itself. Here we see that SNDK has spent 20% of its Enterprise Value over the last three years just on R&D in an attempt to achieve a lower cost per gigabyte than its competitors.

Third, the drive to lower costs often leads to commitments that would not normally be desirable. For example, the surest way to lower costs is to work toward a more fixed cost basis and then attempt to ramp up units sold, achieving increasing economies of scale. This is known as operating leverage and increasing it has been SNDK’s strategy:

Our strategy of investing in captive manufacturing sources could harm us if our competitors are able to produce products at lower cost or if industry supply exceeds demand. We secure captive sources of NAND through our significant investments in manufacturing capacity. We believe that by investing in captive sources of NAND, we are able to develop and obtain supply at the lowest cost and access supply during periods of high demand.

While the company does have some non-captive manufacturing in which it has some swing capacity via third party manufacturers, the bulk of its product is done in-house through a joint venture with Toshiba.

It is important to note that operating leverage, like financial leverage, cuts both ways, so as demand declines those fixed costs remain the same and losses begin to mount. So SNDK’s strategy of increasing operating leverage in order to achieve greater marginal profitability is increasingly risky as the company is relatively worse off during times of lower demand. From a review of the company’s recent 10-Ks, we see that it has been continuously increasing its investment in these joint ventures in order to maintain its cost advantage. Like a company that continuously increases its financial leverage, investors should find a company that continuously increases its operating leverage to be highly risky and thus unattractive.

There are other negative consequences of this strategy. As I mentioned, the company has a joint venture with Toshiba for manufacturing in Japan. The arrangement is that both SNDK and Toshiba purchase 50% of the manufacturing output of the JV at the cost of production plus a given markup. The problem is that sales are largely in USD while manufacturing costs are incurred in Japanese Yen (JPY) which has gained 46% over the last five years. This acts as a drag on the company’s performance (the company does utilize hedges, but this only delays the ultimate reckoning when there is a clear long-term trend in currency exchange rates). Unfortunately, this is not the biggest problem.

The larger issue with these joint venture arrangements it that they are structured as variable interest entities (VIEs) in which the company owns just a hair under 50%, giving Toshiba control. First, as a VIE, SNDK has been able to push obligations it has on behalf of the VIE off its balance sheet, understating its liabilities. Here’s what the company says about these guarantees (emphasis added):

For semiconductor manufacturing equipment that is leased by Flash Ventures, we and Toshiba jointly guarantee on an unsecured and several basis, 50% of the outstanding Flash Ventures’ lease obligations under original master lease agreements entered into from March 2007 through November 2011 and refinanced master lease agreements entered into from April 2010 through November 2011. These master lease obligations are denominated in Japanese yen and are noncancelable. Our total master lease obligation guarantee as of January 1, 2012 was 56.5 billion Japanese yen, or approximately $732 million based upon the exchange rate at January 1, 2012.

Thus, investors need to account for the fact that there are significant off balance sheet liabilities related to its manufacturing operations.

The other issue with this structure is that, when a company does not have control over its subsidiary (either owning more than 50% or via contractual arrangement), it accounts for the subsidiary via the equity method rather than the consolidation method. Under the consolidation method, we would see all of the JV’s liabilities, assets, revenues and expenses show up on SNDK’s financial statements, with a minority interest line deducting the portion attributable to Toshiba. This would more accurately represent the true cost structure of SNDK. Instead, SNDK uses the equity method, which means that only its share of the (meager) profits of the JV shows up on its income statement and only its portion of the equity in the JV shows up on the balance sheet. The effect of this is that profitability appears greater and leverage appears lower.

So there are a few things here that leave me unhappy with SNDK’s decisions regarding how it reports financials, all stemming from its JV with Toshiba. On its own, I wouldn’t be as worried because we can adjust the financial statements to be more representative. But the larger issue is that SNDK operates in an industry with unattractive economics that create incentives to increase operating leverage, which increases risk.

I’ve tried to make the case here that, while the company has performed well over the last few years thanks to its captive manufacturing and economies of scale, investors today are reliant on the good times continuing. If declining demand for the company’s products persists, the double edged sword of operating leverage will come back to sting investors. The rapid decline in gross margins this past quarter is a testament to how quickly things can change. Consequently, I would have to see the share price fall much further in order to get interested.

Oh, one more thing. The company has a shareholder rights plan to entrench management and directors at the expense of shareholders. I hate that, and so should you.

Author Disclosure: None

Talk to Frank about SanDisk

Peter Thiel on 60 Minutes: $1 Trillion in Student Debt is $1 Trillion in Lies about Higher Education

Frank Voisin — Mon, 21 May 2012 09:00:32 +0000

For those of you who have been following Blake Masters’ notes from Peter Thiel’s startup course at Stanford (now on class 13!), I thought I would draw your attention to this CBS segment on Thiel’s new program designed to convince students to drop out of school:

A billionaire’s program to pay students with promising ideas to drop out of college and develop those concepts for the good of all is attracting students and critics. Internet business pioneer Peter Thiel thinks his program is a viable alternative to what he sees as a largely ineffective university system where costs far outweigh benefits. But others say Thiel’s program, “The 20 Under 20 Fellowship,” which pays $100,000 each to at least 20 students each year, is an elitist ploy that only encourages others to drop out or not attend college at all. Morley Safer takes a look at the controversial program and the increasingly expensive university system that helped spawn it on 60 Minutes, Sunday May 20 at 7:00 p.m. ET/PT.

“We have a bubble in education, like we had a bubble in housing…everybody believed you had to have a house, they’d pay whatever it took,” says Thiel. “Today, everybody believes that we need to go to college, and people will pay– whatever it takes.” And that’s way too much these days says Thiel, when people without a degree can make as much as those with an advanced one. “There are all sorts of vocational careers that pay extremely well today, so the average plumber makes as much as the average doctor,” Thiel tells Safer.

At a time when only half of recent college grads are employed full-time and tuition has quadrupled over the past 30 years, Thiel believes the system is broken and its promises are hollow. “I did not realize how…screwed up the education system is. We now have $1 trillion in student debt in the U.S… cynically, you can say it’s paid for $1 trillion of lies about how good education is,” Thiel says.

What do you think of this?

Author Disclosure: None

Talk to Frank about Peter Thiel

Arbitron Inc: A Moat and Poised for Significant Growth ($ARB)

Frank Voisin — Fri, 18 May 2012 10:00:57 +0000

Arbitron Inc (NYSE: ARB) is a market research company that has, since 1912, estimated the size and composition of radio (and later TV) audiences for broadcasters and advertisers. The company has no debt, pays a steady dividend, and traditionally has earned strong ROEs thanks to the company’s near 100% market share in terrestrial radio market research.

What I like about ARB is the industry niche it occupies and the moat it has in this core niche. For decades the barriers to entry were quite high because customers were concerned primarily with the reliability of the data being purchased, and so it was difficult for upstarts (even those as part of larger organizations) to establish the credibility needed to gain market share. Looking back at ARB’s historical track record, we see this its market dominance in its relatively uninterrupted revenue growth (thanks largely to contracted annual price increases) and relatively strong gross margins.

In 2007, the company’s gross margins began declining, signalling a potential problem. To understand the problem, we have to understand how the company has traditionally collected its data. Prior to 2007, the company collected data from listeners solely in this manner:

Arbitron uses listener diaries to gather radio listening data from sample households in 297 U.S. local markets for which it currently provides radio ratings. … When participants (known as “diarykeepers”) agree to take part in a survey, they are mailed a small pocket-sized diary and asked to record their listening in the diary over the course of a seven-day period. Participants are asked to report in their diary the station(s) to which they are listening, when they are listening and where they are listening, such as home, car, work or other place. … Each diarykeeper receives a diary, instructions for filling it out and a small cash incentive.

This is a labour intensive process both for the company in terms of identifying and recruiting participants and for the participants themselves who have to fill out the diaries by hand. Over time, participant interest has declined and the company has had a more difficult time finding willing participants:

Response rates are one measure of our effectiveness in obtaining consent from persons to participate in our surveys and panels. Overall response rates for survey research, in general, have declined over the past several decades, and it has become increasingly difficult and more costly for us to obtain consent from persons to participate in our surveys and panels. We have been adversely impacted by these industry trends.

Recognizing the decades-long trend, the company began seeking a new method of tracking that is easier for participants and more accurate. In 2007 the company began deploying the “Portable People Meter” system, which is a next-generation method of tracking radio audiences:

The PPM device is a small mobile phone-sized device that is worn or carried by a survey participant throughout the day. It automatically detects inaudible codes that radio, broadcast television, cable television, Internet and satellite radio and satellite television providers embed in the audio portion of their programming, using encoders provided by Arbitron. These proprietary codes identify the media to which a participant is exposed throughout the day without the person having to engage in manual recording activities. At the end of each day, the PPM device is placed into a base station that recharges the device and sends the collected codes to Arbitron for tabulation.

The roll out of the PPM was expensive, and the company recorded this cost under “Cost of Revenues” since presumably their accountants would not let them capitalize these expenses. During the initial years of the roll out, the company was effectively doubling up its costs, running both PPM and the Diary service in parallel. Going through the company’s 10-Ks and looking at the disclosure on Cost of Revenues, we see that 2011 was the first year where the increase in the cost of running PPM was more than offset by the decrease in the cost of running the traditional diary program. This was also the first year since 2007 that Cost of Revenue as a percentage of Revenue declined:

Year	Cost of Revenue
2006	37.8%
2007	46.4%
2008	50.3%
2009	51.0%
2010	54.5%
2011	52.2%
1Q 2012	44.6%

As the transition from Diary to PPM continues, we should expect to see Gross Margins increase toward traditional revenues. I have been unable to find any commentary about whether PPM will ultimately be as profitable as Diary, but the trend is positive and 2010 appears to be a low point in gross profits.

While a return to historical gross margins an honourable goal, some worry that ARB’s business model is subject to disruption as advertisers turn to more targeted methods of reaching their customers (e.g. internet advertising) and consumer consumption of radio transfers to digital offerings (which are easier to track) like satellite radio. This is a real threat, as the company’s moat in its current niche is attractive only if its niche remains sizable. To get comfortable with an investment in ARB, one would want to know that it is getting ahead of the curve to avoid future revenue disruption.

Indeed it is! Last year, the company purchased Zokem Oy, a Finland based market research technology firm. According to TechCrunch:

Just 4 years after its founding, mobile research firm Zokem has been snatched up for $11.7 million up front, with a potential payout of an additional $12 million through 2014. Their buyer? Arbitron Inc. (ARB) …

Their main product is an SDK which developers can plug-in into their smartphone (iOS, BlackBerry, Android, and Windows Phone) application to gather up all sorts of anonymous data like usage patterns, signal strength, and creepier stuff like location. Zokem had raised around $2M in funding prior to the acquisition, all from European VCs …

This is a big move for the company, which is aggressively moving forward with commercializing Zokem’s technology:

COLUMBIA, Md., April 17, 2012 — Arbitron Inc. announced today the launch of a syndicated, mobile consumer research service in the United States. The Arbitron Mobile Trends Panels™ service is a new research offering that utilizes a proprietary, on-device software meter to provide marketers, content providers, app developers and wireless access suppliers with information on how mobile consumers use apps, surf the web, engage in social media, participate in e-commerce, are exposed to and act on advertising, and employ their device to communicate. …

The Arbitron Mobile Trends Panels service is designed to help marketers, app developers, content and wireless providers answer key questions about the mobile consumer:

how popular is an app overall and by category;

what the key differences in mobile use patterns are by operating system;

how much time users spend with content, apps or activities such as messaging;

how people act on mobile advertising;

where consumers come from to find content;

where they go when they leave; and

what a day in the life of the mobile consumer looks like.

The initial launch includes an opt-in voluntary panel of about 6,000 smartphone and tablet users. The results will be used to market the technology to app developers and other clients in the future. While other software developers can create similar products, ARB possesses the same advantage that has allowed it to compete for a hundred years, a reputation for providing credible analysis and bringing value to its clients.

There is another benefit to this transition. ARB is currently beholden to a small number of customers, as 50% of its revenues come from just 10 corporations (with Clear Channel being the largest, at 19% of sales!). Be transitioning into a mobile market research company, ARB will diversify its revenue based and, over time, possess a less risky revenue stream.

Another thing I like about ARB is that in the past, when it has had a share repurchase program, it has used it aggressively. While this by itself isn’t very interesting, what is interesting is that in the company’s Q1 2012 conference call it announced the Board’s authorization for a new $100 million repurchase plan that expires in two years. Strangely, this was not included in the company’s press release.

With ARB, I see a company that is continuing its long tradition of getting in front of trends by transitioning to a diversified mobile market research company. Its reputation for credible research will serve it well and over the next five years we could see this business become a significant growth driver. In the meantime, the company will be aggressively repurchasing shares and we should see its gross margins revert toward stronger historical levels. All of this portends a healthy future.

For those interested, I also found this interview with Dan Moore of CJS Securities about why ARB is overlooked and undervalued:

What do you think of ARB?

Author Disclosure: None, but may initiate within the next 72 hours.

Talk to Frank about Arbitron

China and the Concrete Scowl

Frank Voisin — Fri, 18 May 2012 05:18:31 +0000

Keep this chart in your back pocket for the next time someone tells you that China’s infrastructure investments are reasonable or sustainable:

(h/t ZeroHedge)

What do you think of this?

Author Disclosure: None

Talk to Frank about China