$GAIA - what the numbers mean

I previously wrote about Marty Whitman's insights on Value Investing. One key insight is to focus on what the numbers mean and not just what the numbers are. I cited several examples to highlight this point, and one of them was $GAIA. I got many questions on why $GAIA makes sense as an investment and I am attempting to answer some of them here.


I bought $GAIA when it had just sold off its yoga apparel business. The story was quite simple  at the time- Jirka Rysavy, an owner / operator with history of creating wealth,  was choosing to focus on streaming business and chose not to participate in tender offer. Most of the value came from cash and building near Boulder, CO. And if the streaming business didn't take off as expected, there was downside protection. $GAIA management also said that they could be profitable at any time with 90 day notice.

So $GAIA at first was the type of investments I am most comfortable with -- where things are so clear that its just simple sum of parts type of math and no complicated model is needed.

Since then, the subscription biz has grown (66% growth in subscribers from Q217 to Q218), and cash has dwindled (now $41M after recent equity raise).  So, now we need to look at whether the growth spend is good investment or torched cash.

Subscription type businesses cannot be valued based on earnings. This is because marketing spend to acquire customers is more like growth capex, but is expensed according to GAAP rules. So its cash outlay at the beginning, and it gets recouped (hopefully) over time. Customer Acquisition Cost (CAC) and churn are two important metrics here. I recommend this and this article from Tren Griffin ,and this Bill Gurley article to get deeper understanding beyond just mathematical model. Particularly relevant is the following quote from Tren: A business can start out with very high CAC and then have it drop over time (Sirius XM or Netflix) or have relatively low CAC and watch it rise over time (Blue Apron).  The case of Blue Apron is particularly illuminating as seen in this excellent twitter thread by @modestproposal1

Blue Apron didn't give churn, so here's a rough cut at GP$/Cost Per Gross Add with 3%/4%/5% churn. Bunch of simplifying assumptions. pic.twitter.com/sT63SNBaPV

— modest proposal (@modestproposal1) June 2, 2017

Two key concepts here:

1. Is CAC increasing or decreasing? If company is chasing customers who don't care enough about the product, CAC is likely to increase. CAC is also increasing when many competitors try to bid up the same Google adwords.
2. ARPU, LTV, CAC, churn are all related rather than independent variables. The LTV model is simply a tool to measure how "good" are the investments made by management.


The chart below shows sensitivity analysis based on range of churn rates for $GAIA. My guess is that the churn is closer to 5% because management keeps saying that they keep customer acquisition cost below 50% of LTV. The Marketing expense numbers are from different earning calls.

What's working for GAIA:
1. Cost per Gross Addition (CPGA) is flat to slightly down.
2. Even with close to 5% churn,  management statement that they are not spending more than 50% of LTV seems to be correct.
3. They have plans to increase ARPU from the more loyal subscribers by doing live events at their Colorado office space
4. They own the 80% of their content and content production costs are low.
5. They don't have competition in the Truth Seeker area to acquire customers (compared to Yoga where there's other competing apps, and free stuff on Youtube)
6. They will working on getting more organic growth via friend referral (share a video for free with a friend).


There's still lots we don't know. We don't know the churn by type of customer (Truth Seeker, Yoga) and acquisition channel, and if the churn is going up for each cohort or going down. And we don't know the CAC by different customer types. The comments from Management indicate that the Truth Seeker area has lower churn than Yoga area, and so management if focusing on growing Truth Seeker community. Perhaps the best way to understand what's going on is to focus on management's role as investor of capital (Whitman says that this role is not emphasized as much as it should be). To gain new subscribers, they are making investment decisions in the form of marketing spend - Which customers to target? How much to spend for acquiring these customers?  Its re-assuring that the people making these decisions have long track record of creating wealth and their own money is tied into it in form of stock ownership. Management even bought more stock in the recent equity raise. This leads me to believe that the management is making good investment decisions.  And I am happy to ride along as a stockholder.

Marty Whitman on Value Investing

I recently re-read Marty Whitman's book - Value Investing, A Balanced Approach. Whitman's writing is a bit academic sounding and hard to understand, but his insights are amazing. I find that his ideas on creating wealth and resource conversions provide an investment edge because these ideas don't screen well. Whitman says that earnings are not the only form of wealth. A quick way to understand this is Paul Graham's example of creating wealth by fixing a beat-up old car. There are no earnings if this car is not sold, but wealth or economic value has been created. Similarly, Whitman explains how companies can create wealth in tax efficient manners.

Here are some key points from the book:

1. Focus on what the numbers mean, not what the numbers are 

Whitman says that GAAP earning is a starting point and is an accounting tool, and is not meant to capture economic reality. His advice: Start with earnings and make adjustments to account for economic reality. Whitman is NOT advocating for accepting adjusted earnings as peddled by management, but to create one's own estimate of earnings that mirror economic reality.

Here's one example from the book to illustrate the point of focusing on what numbers mean: Forest City Class A shares in 1991 were selling for $20/share though the annual report stated that the appraisal of income producing assets alone came to $80/share. The disconnect existed because real estate environment was depressed and Forest city reported GAAP losses. The earnings were depressed due to depreciation and amortization for accounting purposes. In reality, the value of the buildings was increasing.

My previous investment $FRPH (now sold) reported GAAP losses in almost all quarters, though they were significantly enhancing value by putting land parcels to higher use (i.e. resource conversion) either as residential buildings or industrial warehouses. The owner operators - the Baker family - didn't prioritize earnings but were focused on lowering taxes and enhancing economic value via resource conversion.

Another example given by Whitman is that GAAP Current assets maybe more like fixed assets in case of going concerns (Eg: Sears inventory is almost a fixed asset if it needs to be in business), while Forest Cities can sell fixed assets such as Class A building by placing a phone call, so this fixed asset is more like current asset in terms of economic reality.

Fast growth software companies present similar challenges when using GAAP earnings. One of my current investments - $GAIA shows big losses on income statement because they are spending lot on marketing and acquiring new users. This marketing spend is expensed by GAAP rules, though it in reality this spend is similar in nature to growth Capex. $GAIA is creating wealth but its not visible from the income statement.

2. Incorrect and excessive focus on earnings

Whitman attacks Wall Street's obsessions with reported earnings. Earnings are volatile and yet they are treated as the most important item when Wall Street looks at companies. He explains that private owners of business create economic wealth while minimizing taxes by reducing earnings.


3. Resource conversion = converting assets to higher use

Whitman maintains that this is the most common way of creating wealth. Resource conversion includes redeployment of assets to other uses, to other ownership, or both.
Examples are:
1. New ownership which will pay considerably higher to acquire the company (eg: M&A, LBO)
2. Use of existing asset base to create large new NAVs (eg: Forest city, Tejon Ranch, St Joe)
3. Use of existing asset base to realize markedly improved earnings and ROE during next up cycle, eg: US semiconductor equipment stock, Tecumseh Products stock

Companies go through M&A, spinoffs, recapitalizations, MBO, LBO, etc quite often and yet the market mostly focuses on analyzing companies only as going concerns and not as resource conversion opportunities.

At the most basic level, Whitman is asking value investors to look at companies from the lens of private, control owners and not just minority stockholders.


4. Management = operators + investors

There is overemphasis on the role of management as operators, but not enough as investors. If one considers that resource conversions happen often during a company's lifetime, it follows naturally that management's role as investors is as important as their role as operators.


5.  Balance sheet strength can translate into cash flow strength

A strong balance sheet can be a source of strength and lead to improved cashflows in the future.

Whitman gives example of Nabors post bankruptcy where there was no debt on the balance sheet in mid 1988. Other oil service companies at that time were burdened with lot of debt. Nabors used its financial strength to buy contract drillers and contract driller assets at cheap prices because they were the only ones bidding. The result was that cashflow from operations went from loss of $20M in 1987 to positive $200M in 1997.


6. Access to ultra cheap financing can be a source of value

Wealth can be created by access to cheap source of capital. Examples are banks and well managed insurance companies