Antipodes Partners: 'Disruption' fever is masking immense opportunity in incumbents

Eugenia Jiménez
Antipodes Partners: 'Disruption' fever is masking immense opportunity in incumbents

Disruption has become one of the most used words in modern investing. The bifurcation of sentiment and valuations among those deemed as victims and those as initiators has often become extreme.

Investor fervour to ‘be on the right side of change’ has not only driven the valuations of the perceived winners to excessive levels, it has also resulted in the overlooking of many fundamentally sound businesses.

We have witnessed numerous examples of this in recent times and have taken the opportunity to buy into many high-quality businesses trading cheaply relative to any reasonable assessment of medium term prospects. Below are three sectors where we believe it pays to look beyond the disruption hype:

Forget the FANGs

The ‘disruption’ dash is clearly evidenced in the technology sector, where we have stakes in incumbent stocks such as Netapp and Cisco Systems.

NetApp, one of the two dominant providers of enterprise storage systems over the past two decades, is a good example of sentiment temporarily trumping reality. The rise of Amazon’s public cloud services, part of which comprised cheap commodity storage, began to eat into the market for dedicated storage vendors such as NetApp.

While this market shift was indeed real, the market by early 2016 had become convinced traditional storage was dead and NetApp’s shares traded at just 4x free cash flow. Fast forward two years and NetApp’s business has evolved substantially. With the accelerated introduction of a new operating system, the company has leveraged this to become the fastest growing company in the ‘all flash’ storage segment, with hard disks giving way to solid state flash memory for many high end corporate and web-scale environments.

Until recently, Cisco’s shares traded at less than half the valuation of comparable companies. The growth of web-scale vendors has placed different demands on networking providers – with the growing client preference for customised, rather than out of the box, solutions. It is entirely within Cisco’s capabilities to address this need, as few are better resourced or know more about networking than Cisco.

Cisco’s business model is also evolving as it layers deeper software capabilities into its solutions, providing a pathway to deliver its technology stack via subscription, rather than product sales. While this has created a short-term headwind to reported growth, it will significantly grow customer lifetime value as subscriptions are adopted. For now, Cisco’s valuation offers a significant margin of safety and recent tax reform has provided a further boost.

Autos charge on

Another area of the market under the disruption spell is the automotive sector – with Tesla one of the world’s largest manufacturers in market capitalisation terms. However, on almost any other financial metric it is an over-promoted niche automaker, with a nonsensical valuation and heavily challenged finances.

The perception of Tesla as a disruptor of the century-old global auto industry has left many companies trading on unjustifiably low valuations. Hyundai Motor Company is one such example. Hyundai’s stock is available for purchase on less than 2x pre-tax profits, once we conservatively adjust for the value of group investments and its $12bn cash pile.

While we do not doubt the transition to electric vehicles presents long-term challenges for all automakers, we believe spinning out non-core assets, lifting dividends and buying back stock would be incredibly value-enhancing for Hyundai’s minority shareholders. By contrast, operating profit for Tesla will remain negative until at least 2019, with the company trading at almost 17,000x EV/EBITDA. Hyundai is under 0.5x EV/EBITDA, by our metrics.

The valuation discrepancy could arguably be justified if the prospects for the businesses were entirely divergent, but Tesla operates in the same economic universe as other automakers – while it also faces its own challenges. For example, the manufacturing ramp up of the mass-market Model 3 continues to be delayed by battery module issues.

We have enormous respect for Tesla’s achievements, as it almost single-handedly changed the perception of what is possible. However, this does not make it a good investment. While the first mover in the electric vehicle space, Tesla is now facing increasing competition from the major automotive companies, many of which have large cash resources. These incumbents – such as Volvo, BMW and Mercedes – are making significant strides in electric vehicle R&D and can leverage major brand recognition built up over many decades.

Amazon or bust

Though the US office supplies market has consolidated down to Staples and Office Depot, these two extremely dominant businesses are considered dinosaurs facing extinction by Amazon.

Office Depot has two business lines – commercial and retail. Commercial covers large corporate office delivery and accounts for about 50% of revenues. The other half comes from retail, serviced by a national network of 1,400 stores. After a blocked takeover attempt from Staples, Office Depot’s share price plunged 40% and we sensed an opportunity – on the belief the market was underestimating its inherent resilience against online competition.

We are not denying the online/Amazon threat is significant, but Amazon is not perfect. It is struggling to optimise its low-cost service model for commercial customers, often with slower delivery times versus same day at Office Depot and deploying multiple delivery batches for bulk orders.

Office Depot belongs to our ‘retail disruption’ correlation cluster – which includes traditional offline retailers successfully confronting and adapting to the online reality that the market is overlooking in its fervour to believe that Amazon truly is the ‘the everything store’.

By Jacob Mitchell (pictured), CIO of Antipodes Partners and manager of the Antipodes Global Fund – UCITS

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