For the six months ended June 30, our average account was down -24.17%.
In our letter to you last quarter, we pointed out that we had lightened up on some of last year’s best investments, and were likely to do some more selling as the quarter went on. As things turned out, we might have been better served in taking more care reading these letters ourselves. There are few things more galling than not taking enough of your own good advice. Obviously, we might have happily sold even more than we did. Nonetheless, we are optimistic about the second half if only because the first half has been so very over-done.
We pointed out in early April how foolish it was to accord enormous valuations to companies that lost large sums of money and had nothing more by way of assets than thoroughly dubious business plans. Not two weeks later, the market suddenly agreed, and the carnage in the internet sector has been truly awful to behold. Less obvious at the moment, is exactly how many babies are being thrown out with the bathwater. Perhaps it’s more than a few. Two we can vouch for, however.
When we bough Qualcomm a year and a half ago, it was with the understanding that it owned what might turn out to be the most lucrative toll booth of all time. It had the underlying patents to a new form of digitalized cell phone telephony, and that system was likely to triumph as a standard because it allowed for much greater data transmission speeds than any competitive system. That latter clause bears amplification.
When most of us think of phones, we think of voice; wrongly, as it turns out, because over the last three years 90% of the growth in traditional land-line telephony is data. If cell phones are to become more than a toy for teenagers and far too uninhibited grown-ups, data transmission is a must. How many CDMA users there are in the world, and how fast the new data-bearing chips get produced, are, to us, the key variants in this investment. Everything else is noise, and most particularly distracting is whether they get a splashy order for semiconductor chips from a Chinese telecom carrier.
The market to wrestle over is rich America, not poor China. No matter what we think, however, the market at this moment persists in treating this company as a semiconductor house hungry for throughput. Qualcomm does not own a semiconductor factory, and its royalty payments must be ten times more than any manufacturing profits if we are to be rewarded, but the stock market can be obdurate at times. We are certain that opening envelopes full of royalty checks from other people’s manufacturing efforts is a far better business than making anything yourself. We are a little less sure that it is Qualcomm that will be the undisputed winner; after all, the cutting edge of technology is always the most unstable of platforms to stand on. But we never get tired of contemplating that the cell phone market this year is thought to be in excess of 400 million units, up 50% from last year, and triple the number of personal computers sold.
If we sell the company that stands astride this it would be a little like selling Microsoft in 1987 because the Christmas selling season for PC’s was a disappointment. Qualcomm is profitable, debt-free and cash generating. There is a limit to how much damage the world’s opinions can do you when you are in that position.
As for Echostar, the quarter was a study in perversity. We sold some shares early in the quarter, we stopped when the first quarter’s results were amazingly good, and then watched the stock sell-off for the rest of the half. Here again, we feel hoist on our own petard. Echostar “apparently” loses money, and if it cannot make money with its current subscriber base of 4.3 million, isn’t it like just another dot.com caught in mid-leap, before it had reached the profitable far shore?
No. We put the word apparently in quotes above because Echostar is solidly profitable now, using standard accounting. Indeed, if you amortize the cost of getting a new subscriber over the average life of that customer, and deduct that sum from gross profits, Echostar is earning about $2 a share, untaxed, at its estimated year end subscriber count. The stock is 38, so it is hardly an extravagant multiple for a fast growing media business.
The problem arises in that they do not use standard accounting. They expense the cost of getting a new subscriber the instant they sign one up. Consequently, the faster they grow, the more money they “lose”. This screwball outcome is a hangover from their start-up days in 1996, when the SEC urged it on them, not knowing if there was any market for small dish satellite TV. Today the upfront absorption of costs saves them from any tax bill, an obvious attraction to Charlie Ergen, the CEO, who also owns half the outstanding stock. One would think that trained analysts would instantly see through such a basic accounting issue and grasp the inherent profitability of the underlying company, but we have never been on a conference call that someone doesn’t pipe up with, “When are you going to be cash flow positive?” That point was reached two years ago, when we started buying, but it doesn’t seem to have trickled down to Wall Street even yet. Meanwhile, we are the beneficiaries of a 70% growth rate, even if, for a little while, we’re the only ones who know it.
Our other investments continue to do well as businesses, and continue to mark time as stocks. This is alright with us; so long as there is vigorous underlying growth, value will out when it will out. Conversely, we do think our two biggest holdings are badly misunderstood just now, and confusion is the best atmosphere for outsized performance. Here’s hoping.
Wishing you and yours the best we are,
Sincerely,
Edwin A. Levy
Michael J. Harkins