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Henry Ellenbogen's Bet on the Future Pays Off -2-

19 Aug 2017 4:33 am

Innovation significantly impacts what we do on the durable-growth side. We made a lot of money in Papa John's International [PZZA]. In 2012, we woke up to find that the rules of pizza delivery were being rewritten. Pizza sellers compete on quality, value, and convenience, and the national guys weren't winning on quality. Nor did they have an advantage on value and convenience. Then, Domino's Pizza [DPZ] started to invest in technology and its app and convenience. We realized the company's growth was real, and bought Papa John's. It was also benefiting from these trends.

We began looking for other companies that use technology to change the way they relate to customers and gain market share. That led us not only to Vail, but to Rollins, [ROL], which owns Orkin Pest Control. As with pizza, there are only two national pest-control players -- Orkin and Terminix, each with about a 20% share. Orkin is using its technology not only to improve its relationship with customers but also to work more efficiently with service technicians. Last year, Orkin introduced a communication system that basically involved arming technicians with iPhones. It fundamentally transformed the efficiency of the company. Like Vail, Rollins is gaining sizable market share.

Which stocks look attractive to you now?

Vail has created a best-of-breed set of assets. Underlying this business model is business-model innovation -- namely, the season-pass program. Vail makes the best assets more valuable by selling them as a network. Also, when the company acquires assets, it generates higher returns on capital than other operators. It is generating about a 20% return on acquisitions. But skiing is market-sensitive, as destination skiing is a very expensive pursuit. If the stock market falls, that will impact the stock in the short term. On the other hand, millennial trends are powerful here, and you don't have to worry about competition from Amazon.com [AMZN].

Good point. Are the shares cheap?

Vail trades for $220, or about 14 times estimated 2019 free cash flow. The business model deserves to trade for 20 times free cash. Based on estimated earnings before additional acquisitions, it seems Vail could trade in the low- to mid-$300s in coming years.

Guidewire Software [GWRE] provides systems for record-keeping in the insurance industry. It has about a 30% share. The next-largest competitor is about a tenth its size. The company continues to gain share, and has finished its first deployment to cloud computing. When you go to the cloud, there is about a three-times revenue multiplier. Not only will Guidewire continue to gain market share, but revenue will grow as clients move to the cloud.

When you are the key systems provider to an industry, everyone's data is in your data set. As our work on machine learning revealed, it isn't only about the uniqueness of your data, but also the fact that it is actionable and properly categorized. Guidewire is early in its life cycle; we estimate what normalized profit margins might be in a couple of years, and put a multiple on that.

Guidewire is trading for $71 a share. What could it be worth over time?

The company could continue to compound by 20% a year for several years.

Liberty Expedia is another favorite. John Malone controls Expedia [EXPE], the online travel site; Liberty Expedia represents his control shares. Eventually, Expedia will probably buy back the control shares and pay a premium for them. If it performs the way we think, and Liberty Expedia is acquired for stock, we would probably want to hold on to our Expedia shares.

Expedia's HomeAway vacation rental marketplace is significantly undervalued. Expedia paid $3.9 billion for HomeAway, which is about a third of the size of Airbnb. Under Expedia's leadership, the management team changed. HomeAway has transitioned from a subscription to a transaction business, which is better for the hosts and customers. The transition allowed the company to unlock capital and build scale. As investors gain an appreciation of Expedia's strength in the alternative-accommodation market, and view it as a share gainer, the stock will rise. You could make 50% to 70% over three years.

You mentioned the millennial mind-set. What distinguishes it?

We believe that millennials aren't a demographic, but a psychographic. Understanding this explains why we have done so well with consumer-discretionary investing. Millennials trust technology over brands. They consider user reviews more important than paid marketing. They value experiences over other kinds of consumption. This has put a lot of stress on retail.

The retailing industry was about replication. Get the concept down at headquarters and roll it out to the nodes. A couple of years ago, we realized that many of the replication stories we were invested in just weren't working. The trends were changing. Grubhub, the online food-ordering and delivery company, is a consumer stock we like. It combines the mind-set of the on-demand economy with the force of technology. What is misunderstood about Grubhub is the massive change in consumption patterns. The food-takeout market is about $70 billion. Excluding pizza and Chinese food, less than 10% is delivered. In the next 10 years, what happened in pizza will happen with other meals.

How much upside do you see for Grubhub?

Grubhub's organic revenue growth is sustainable in the low-20% range for several years. Profit margins and the multiple can hold. The stock is around $54. It could rise by 70% to 100% in the next three years.

Thank you, Henry.

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August 19, 2017 00:33 ET (04:33 GMT)

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