We Study Billionaires - The Investor’s Podcast Network - TIP509: Value Analysis of Warner Brothers Discovery, Lithia Motors and Meta w/ Bill Nygren & Alex Fitch

Starting point is 00:00:00 You're listening to TIP. Today, we welcome back legendary investor Bill Nykron of Oakmark, as well as fund manager and director of research, Alex Fitch. We always value the insights we glean from the experts at Oakmark, and today we have a lot to talk about. Earlier this year in March, Bill and I discussed Facebook's transition into meta on episode 430. We touch on how the Oakmark thesis has played out since, given the high level of controversy

Starting point is 00:00:26 surrounding the company. Additionally, we do a couple of deep dives into what appear to be. be very undervalued stocks such as Warner Brothers Discovery and Lithium Motors. In this episode, you will learn Oakmark's framework for navigating the current market, Bill's updated thoughts on Meta and Bank of America, how the Warner Discovery merger has caused a lot of confusion in the market that may have now resulted in a severely undervalued stock, how lithium motors is quietly capitalizing on the use car market and its newer direct-to-consumer platform, how Lithia compares to

Starting point is 00:00:55 competitors such as Carvana, whose stock is nearly crashed completely and much, much more. It's always a pleasure to speak with such brilliant investors like Bill and Alex, and I know you'll get a lot out of this one. So with that, please enjoy this conversation with Bill Nygren and Alex Fitch. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to the Investors podcast. I'm your host, Trey Lockerbie. at the top, I'm here with Bill Nygren and Alex Fitch. Welcome to the show, gents. Thanks for having us. Yeah, thank you, Trey. Good to be back.

Starting point is 00:01:45 So, Bill, I wanted to kick things off with you. In your Q3 commentary, you wrote that it is somewhat reassuring that we have endured the duration and magnitude of the average bear market. And while, of course, things could always get worse from here and the S&P 500 did steep further in October since you wrote that were essentially flat now from the time you wrote it a few months back, how do you typically approach markets like we've seen this year? And have you found many opportunities along the way? Yes, absolutely. We've been able to find a lot of opportunity. Let me step back and talk about why I wrote that piece. I was getting a little bit annoyed with the financial media, basically telling people, now that we're in bare market territory,

Starting point is 00:02:25 after the market's down 20 percent, now's the time to start being more careful and more risk-conscious. And they were saying the same thing about we'd had two quarters of GDP decline in a row. Typically, that's called a recession for some reason this year politically, I guess it didn't want it to be called a recession. Also, we'd had inflation numbers that were reading 8% year over year. So I wanted to go back and say, what has actually happened in the market? If you invested, once you knew we were in a bare market, once you knew we'd had two quarters of down GDP, Once he knew inflation had gotten out of control again. And what we found, no surprise for a firm like us that doesn't try to be market timers,

Starting point is 00:03:12 is that once the news was out, it was too late to sell. And the typical bear market, after it's down 20%, it continues to go down. It hits ultimate bottom about six months later. And I pointed out, if the market followed that same trajectory, it would go down another 10%. that bottom would be somewhere around October, and that's basically what we went through. Now, of course, that's no guarantee that we're done with the market going down, but I thought it would be comforting to individuals who were thinking, maybe I should sell because we're in a bare market, to know we've already experienced what a normal bare market has been.

Starting point is 00:03:52 And we've already experienced the decline of a normal recession and already experienced the decline of high inflation. So at Oakmark, as you know, what we try to do is estimate the long-term business value. And then we look for large deviations between the stock price and that estimate of business value. And with the market down so much, it's no surprise. We're seeing more names that we're meeting our criteria being significantly undervalued. I think one way to look at that is to look at the portfolio turnover we've seen. Typically, the Oakmark Fund owns just over 50 names, and in a 12-month period, you might see us have 10 new ideas.

Starting point is 00:04:33 In just nine months, I believe we had 12 new ideas. And in the Oakmark Select Fund, much smaller portfolio, only about 20 names. Typically, we see about four new names in a year, and in just nine months, we'd already seen eight new names. So we see the volatility, and the more you spread out the performance, the greater the opportunity for us to sell the names that have held up well and then recycle those dollars in the names that have become attractive. So, Bill, a little bit further on that, when you mentioned stocks becoming overvalued and now maybe undervalued, how are you juggling that when interest rates keep rising and, you know, your discount rates, assumingly, are changing?

Starting point is 00:05:17 Well, we always define business value based on alternative investments. And one of the alternatives that an investor has is a long-term bond. We look at about a seven-year bond, trying to come reasonably close to matching the duration of an equity in a bond. And for many of the past years, when we had interest rates close to zero, we were artificially inflating the discount rate that we required for an equity because we thought interest rates were unsustainably low. Now, they've risen enough that they've gone above our floor interest rate. And as rates go up, it decreases the value of all of our investments because the alternative that an investor has to invest risk-free in a similar duration asset has become significantly more attractive. So over the course of this year,

Starting point is 00:06:10 you've seen probably our average stock have a decrease in estimated value of somewhere around 10%. But the markets come down significantly more than that, and more, importantly, it hasn't been uniform. You've had some companies that have held up unbelievably well and are actually up year-to-date, and then a lot of others that are down more than 50%. And it's that spread between the names that have held up well and maybe the percentage of business value that they sell out has actually increased this year versus those companies that have come down significantly more than the market and also fallen a lot more than their business value has fallen. So that's really what we're trying to capitalize on is taking advantage of where investors

Starting point is 00:06:56 have become disconnected with long-term business value and those stocks are available at a cheaper fraction of business values than they were a year ago. So, Alex, Bill just mentioned the Oakmark Select Fund. And that fund has underperformed the S&P 500 this year by quite a margin. The largest detractors to performance have been meta, charter, and alphabet. Did the thesis change with any of these picks or did you find opportunities to actually lower your cost basis? I would build on what Bill said about interest rates and just say that I think the biggest surprise to us if we went back to January 1st of this year. And you told us that interest rates were going to go from 0% to almost 4%.

Starting point is 00:07:39 I don't think we would have guessed that it would have hurt our portfolio as much as it has. Interest rates clearly reduce the value of some of these faster growing businesses, the tech companies where you have long duration cash flow. those that are worth less today. It should on balance help the value of financials and of our bank holdings, right? These are companies that have spent the better part of 15 years plagued by low interest rates, right? Where even if you pay zero on deposits, you can't lend it a high enough rate to earn a historical interest margin or historical spread. And you're seeing interest margins climb back towards historical norms and it's driving a lot of earnings growth. And, you know, in our view, that is a very good thing for business value. There's some,

Starting point is 00:08:20 much concern about a recession, though, and so much of this investor tendency to be like the general fighting the last battle and worried about another 2008-like crisis. And I think there's not enough appreciation for just how much the banks have changed over that period. You've seen equity capital levels of the largest banks roughly double. You've seen liquidity increase. You've seen their reserves grow significantly through new accounting rules. You've seen their funding sources move towards stable deposits instead of the kindness of

Starting point is 00:08:49 strangers in wholesale markets. And so, you know, line item after line item in the bank financial statements, we think have changed in a way that reduces the risk. And yet investors are, I think, treating them as if they're just as dangerous as they were 15 years ago. In a way, I think that's potentially, it might mean that a recession is the best thing that can happen to bank values over the long term. As to the companies you specifically noted as detractors, when a given name starts underperforming our fundamental estimates and we're worried about our thesis being in correct. We have a pretty standard process for addressing that. I think Netflix is a good example. Earlier this year, they disappointed on some subscriber growth two quarters in a row. The stock fell from

Starting point is 00:09:30 $600 a share to 160. Our reaction to that was to take Netflix and talk about it as a team in our investment committee and to have one analyst take over as a devil's advocate making the case for why we should sell Netflix. We meet with management. We sit down as a group. We debate the assumptions and we decide if we still have confidence in our investment thesis. And with Netflix, the reaction and the ultimate conclusion was that we do have confidence. And so we bought more shares near the lows. And I think the subsequent performance has, at least thus far, vindicated that decision. It's the same process for some of the names you listed, where we're going to reevaluate our assumptions, have a devil's advocate review, and come to conclusions. And there's no guarantee on the same outcomes, but that's the process.

Starting point is 00:10:14 If I could just chime in, you know, Alex was talking about how the concern about recession has hurt financials. Something I've been saying is, I think anybody under 40 years old hasn't been in this profession during what I would call a normal recession. We had the recession that was induced by the pandemic two years ago and then the great financial crisis back in 08. And those are almost more like generational recessions. That's why they call it the great financial crisis because it was so much worse than a normal recession. Most of the recessions that that I've been through in my career are more like what we were going through in the first half of this year, where you see GDP go down a little bit. There's debate about whether or not you'll see that happen

Starting point is 00:10:59 for another quarter. And by the time you have it pronounced as a recession, there are already green shoots suggesting that we're on the way out of it. And you might even have an upyear of GDP. It's just so much more minor than what we went through in the GFC or the COVID recession. I think investors are making a significant mistake when they look at banks and say, well, let's look at what chargeoffs were in the last two recessions. And that'll be our guess of what will happen if we go into another recession in 2003. Normally, the banks in most of my career didn't trade on this like risk on, risk.

Starting point is 00:11:41 off like such pro-cyclical stocks as they have recently. Banks traded more like they were safe havens. And it's because in a typical recession, the damage that's done through charge-offs is just not that big a deal to the long-term survivability of those companies and changes to business value relatively little. It's just, it's nothing like what we went through in 2008. Touching there on banks for a second, Bill. So I'm curious about that because it seems like the Fed is inducing this sort of quantitative tightening in this form of the reverse repo market. So banks are making more on their reserves and then less likely to lend that money out. And it's a form of tightening, if you will. And I noticed that I'm spacing if it's the select fund or not, but I

Starting point is 00:12:28 believe you sold out of your Bank of America position for, you know, in light of something else that was more appealing. And you and I did speak about Bank of America on a prior episode. I was kind of curious how the thesis has changed for you on banks and particularly the Bank of America? I wouldn't say our thesis on banks has changed at all. We certainly have nothing negative to say about Bank of America. But what you see, and we still own Bank of America in the Oakmark Fund. So it's in our 50 favorites, but not in our 20 favorites. What you see in the Oak Mark Select Fund is for a name to be cheap enough for us to own in that fund, there almost has to be significant controversy about that company. And as Bank America navigated the recovery after the GFC and Brian Moynihan

Starting point is 00:13:16 started to be named in lists of best managers or best CEOs in the banking industry, a spread started to develop between Bank America and some of the other banks. And a company like Wells Fargo, where there are still significant question marks, relatively new management team, still a lot of government oversight going on there that some of the other banks aren't having to deal with, the spread of where Bank of America was trading relative to its book value next to where Wells Fargo was trading relative to book, just got to us to look too large relative to what we saw the quality differences of those two companies. So our investment in financials in the select fund are as high as they've ever been. And it's just the names have changed a little bit as to which

Starting point is 00:14:04 ones we think have the best risk return profile. If I could go back to one point, I really want to make sure we don't overlook this. And the question that you asked Alex, you asked if we'd had the opportunity to lower our tax basis in some of these names. And we consider tax management to be a key competency of the Oakmark funds. And I would point out throughout the course of the year, we are always trying to lower our tax basis in any of the names that have gone to. And I'm down in price. And we like to accumulate those losses so that we don't have to make taxable capital gains distributions any more than is absolutely necessary. And neither Oakmark Fund or Oakmark Select Fund will have a capital gain distribution. And despite this year not being the

Starting point is 00:14:53 greatest performance year, especially for Select, the three-year return is still pretty good in both funds. And I think in the Oakmark fund, we've had like just a shade over one percent of capital gains distributed over the past three years. And in Select fund, it's been less than that. That stacks up really well versus our peer group, especially peers that have changed their portfolios as much as we have this year in both Oakmark and Oak Mark Select. So I know sometimes open-end mutual funds get a bad rap for paying taxes when they aren't earning money. We think our tax management allows us to be every bit as tax efficient as a separately managed account or even an ETF fund. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:19:47 Back to the show. So, Billy mentioned controversy, and I can't think of another company with more controversy this year than Meta, which you and I spoke about back in March of this year was episode 430. And given its poor performance this year, I wanted to circle back to see if you think the market simply doesn't like the new mission of the company and the amount of investment required. It's already spent $36 billion since 2019 on this new Metaverse project and is projected to invest a lot more.

Starting point is 00:20:13 Or is the market missing other aspects of the company's future that it isn't being priced in? When meta stock fell after they reported such disappointing free cash flow numbers in the past quarter, we went through the same process that Alex described for Netflix. Let's assign a devil's advocate. Let's meet with management. Basically, to re-underwrite, is this a company that we would be comfortable investing fresh money in? And in the case in Netflix, we came out saying, yes, we're just as comfortable with this as we were when we first bought Netflix.

Starting point is 00:20:47 our meta outcome wasn't as positive. If the apps were a separate company and we could just invest in blue Facebook and Instagram and that cash flow was coming back to us as shareholders, I think we'd be every bit as excited about meta as we were when we first bought it. But that's not what's happening. All of that cash flow and more is getting invested in artificial intelligence and alternate reality. and we're less confident, even with our long-term time horizon, that that has an economic return to shareholders. And maybe it's just because we don't understand it so well. But if we don't understand the rationale behind the investment, we're not as comfortable with it. And you've seen in our monthly releases that our metaposition is less than it was several months ago. And it

Starting point is 00:21:42 will stay that way until we can get confident that there's going to be an economic return on all of this new investment. And I just wanted to add one more comment on meta. One of the things we have always liked about meta is the controversy was almost exclusively on the blue Facebook app. And we think Instagram makes almost as much money as the Facebook app does. I think you can make an argument that Instagram alone is worth more than where meta is selling today. So if we could get confident that the cash flow from Instagram was being invested well, or if they would ever decide to spin off Instagram, that would be an investment that we would be very excited about. Yeah, I very much understand that it's almost like they should spin off the apps portion of

Starting point is 00:22:34 the company into its own thing. And I'd like to maybe, I guess, in the spirit of spinoffs, talk about a different company that's, I think, relatively new to the portfolio. It's the Warner Brothers Discovery. And this company was spun off after the merger of AT&T's Warner Media and Discovery back in April. But the stock, which launched at around a $50 billion market cap, has dropped basically in half, around 50 percent since the merger completed. And Jeff Bukes, who was Time Warner's ex-CEO, he said that the value destruction has been, quote, monumental. The newly formed company essentially kicked off with around $43 billion in debt. And that seems to have led management cutting significant projects and personnel. I'd like to get your take on how the newly

Starting point is 00:23:20 formed company is shaping up. Yeah. So Warner, you know, it's another name with no shortage of controversy. And I think you're taking two big companies, you're combining them, and you're kind of simultaneously overhauling this strategy. So, you know, there was no real scenario in which this going to be perfectly smooth and there was not going to be a bit of disruption. I think AT&T got caught up a little bit in the gold rush in streaming, right? Chasing subscribers trying to spend whatever it takes to become the largest possible streaming business. And it caused them to neglect their legacy franchise. And I think forego a lot of profit opportunities there, right? They pulled back on licensing content. And rather than monetizing content through theaters, they prioritize the DTC segment

Starting point is 00:24:04 and simultaneously drastically increased the amount of spend going towards DTC. And in hindsight, it looks like a bunch of that spending came at very low or even negative returns. Now, you close the deal and you inherit this WarnerMedia asset as discovery with, I think, worse than expected economics given all that spending. And then layer on top of it the fact that some 71% of the owners of the new company are AT&T shareholders, who are predominantly retail investors that are dividend-focused. And the turnover and selling pressure, I think, isn't unexpected. And it is something that Discovery anticipated.

Starting point is 00:24:40 But broadly, stepping back, you know, the deal rationale here is intact. You're combining two of the largest linear players. You have a combined portfolio now that's almost 25% of non-sports television viewing hours, which is a level of scale that's going to give you a lot of negotiating leverage with the cable companies. It is going to enable you to provide better advertising products. to advertisers and increase ad prices. You have an enormous cost-saving opportunity.

Starting point is 00:25:05 The overlapping back office infrastructure that leads to around $3.5 billion of anticipated cost savings, which comes out to more than a dollar a share of incremental earnings power. And you have this logic of combining the two direct-to-consumer businesses where HBO Max has this headline-worthy content,

Starting point is 00:25:23 blockbuster content, and Discovery has this nourishment that drives a lot of viewing hours, but maybe doesn't gather the same level of buzz. And in putting the two together, you have this opportunity to create a streaming service that engages more members of the household, drives more viewing hours, and has lower churn. So the promise of the deal, I think, has always been inherently long term. And it's intact. I think we just unfortunately had a few billion dollars of earnings evaporate in the process.

Starting point is 00:25:50 But discovery management, I think, is taking the right tack, inevitably breaking eggs in the process of putting this new company together. and I think that they have the right game plan. So we're happy to own shares. And I would just add, you know, somebody listening to this might think, why would you ever step in in front of all this controversy? Why not buy something where the consensus is just so much more positive? You know, this stock sells it like four times earnings, expected earnings for next year.

Starting point is 00:26:18 You know, a quarter of the S&P multiple. So there's no question you're getting paid to step into the controversy. And if what Alex outlined is right about the. cost-saving opportunities and the increased revenue opportunities. And this migrates up toward a more normal PE ratio. This stock is going to be an incredible performer. Yeah, maybe just to add to that for a little bit of background, we bought the shares in the third quarter. And they were already down quite a bit from the closing price of the deal and from the highs prior to that. The way that we view the company, it's an $11 stock today. And if you were to just look at the reported results, there's about

Starting point is 00:26:55 $1.50 of EPS this year. You layer on those calls. synergies that I was talking about and the underlying earnings power is $2.50. So we're at, roughly four and a half times earnings. The really incredible thing to me is that that is despite still losing around $2 billion in their streaming segment. And the implication is that the streaming business is worth a negative, being capitalized at a negative by the market in it a very low multiple. Well, Warner Brothers has one of the largest content back catalogs in the business, right? they've been almost 25% of non-sports viewing for years. Warner Brothers Studios has been number one or number two in box office for decades.

Starting point is 00:27:34 You have HBO, which was the original Direct to Consumer Service that used to just a few years ago earned $2.5 billion a year in EBITDA, you know, Game of Thrones, Harry Potter, you have these tent pole franchises. And Warner today is deciding to take all of that value, all of that content and back catalog and try to monetize it through a streaming service. And there's good reason to do that, right? There's a strong case for eventually building enough subs, pricing, and reducing churn to generate very healthy margins there. But the more important thing from our perspective is that even if that proves to be the wrong approach and streaming doesn't work, it doesn't mean that that massive back catalog is worth zero or a negative.

Starting point is 00:28:14 It means that Warner then just has to go back to the old model where you close down the streaming platform, remove the technology and marketing spend and begin licensing all of that content to third. third parties. And, you know, the opportunity to own the Warner Brothers and HBO back catalog, I think, can put somebody on the map from a streaming perspective. And, you know, you could imagine very large payments for access to that catalog by capitalizing negative $2 billion of earnings today in the market. I think the market's ignoring the fact that basically every branch of the decision tree comes to a better positive outcome than where we are at at present. And so we look at the underlying earnings power is something closer to $4 per share and stock it less than three times that figure. So I want to talk a little bit about risk because I believe before this merger

Starting point is 00:29:01 happened, the estimated cost of restructure was around $1.5 billion. And now they're saying it's going to take up to $4.3 billion in restructuring charges, including, I think you highlighted this, but around $2.5 billion in content write-offs. You were talking about the loss of $2 billion and around streaming. I'm not sure if that's what you're referring to. But do you believe at this $11 share price now that we have a margin of safety that's enough to kind of counteract these unforeseen risks and maybe a few more that might perk up along the way. Yeah, I mean, just to put that in context, it's a business that should be in the next couple of years generating, you know, $6 to $10 billion of free cash flow annually.

Starting point is 00:29:40 And so there are numbers that can be absorbed. As for the content write downs and a lot of the restructuring costs, they're essentially sunk, right? It's cash that went out the door years ago where there's some type of. asset on the balance sheet or whatever you spent it on that we're now determining is worthless or worth less. And so it doesn't directly impact the leverage profile of the business. I think the balance sheet is in a reasonable spot. They're on a path to being sub three times levered in the next two years. They have a 14-year average debt maturity. The interest rates

Starting point is 00:30:10 are around 4% that they're paying. So I think from a leverage perspective, it's manageable. And the actual cash charges are just a subset of the numbers that are being laid out. But all of it, within the scope of the broader business economics, I think, is easily manageable. That's funny. The stock's down from, what, like $27 to $11 a share, and people are all bent out of shape over the costs you're referencing that are one time in nature and totaled like one or $2 per share. The market has certainly fully charged the stock for those surprise costs. Now, the newly formed company, as you mentioned, kind of has missed a few quarters of earnings now, and it's just getting skewered by the media, especially the New York Times. They quoted that Discovery has blamed AT&T's mismanagement for the grim results. And in the latest twist, investigated allegations that AT&T engaged in questionable accounting tactics to inflate the projections on which the value of the Warner assets were based. And so much so that AT&T has actually agreed to pay Warner. Brothers discovery, $1.2 billion by the end of August. I'm kind of curious how this plays into your

Starting point is 00:31:21 assessment of management and how you're looking at management going forward with the new company. Yeah, it's a great question. And it is a question that we've spent a lot of time on. You know, you want to make sure that the mistakes that have been made don't, you know, increase your concern that there are going to be more mistakes in the future, obviously. So we spent a lot of time with management and amongst ourselves talking about these issues. I think at a high level, the big problem was that there was an enormous mismatch in the strategic direction that AT&T wanted to take compared to the one discovery wanted to take. And you had this prolonged period between the announcement of the deal and the closing of the transaction where there are guardrails in

Starting point is 00:32:00 place. There's limited information that can be exchanged. And from everything we can gather, there was just not a lot of receptiveness on the part of AT&T to adapting their course based on what discovery plans to do in the future. So for instance, AT&T went ahead with Cienable. CNN Plus and launched it despite what they expected to be a billion dollar burn rate in the first year and not actually including CNN in the product in terms of the live news. And I'd imagine that discovery had plenty of opportunities to indicate to AT&T that this isn't something that they're comfortable with. This isn't something that they would pursue.

Starting point is 00:32:33 But AT&T went forward anyway. And I think it led to some bizarre outcomes like canceling CNN Plus just some four weeks after it launched. And each one of these decisions, I think, it's headlines. You cancel backgirl and it gets headlines. Warner has a tough job. And I am mostly encouraged to see that CEO David Zaslov is willing to execute on that job because there are a lot of uncomfortable decisions that do have to be made. It's not easy to shut down projects that have sunk costs. It's not easy to let people go. But creating the right company to go forward that's going to

Starting point is 00:33:06 optimize the value of each piece of content and try to deliver better profitability, I think requires these steps. I trust his framework. And I think each of them have moved us in the right direction. Inevitably, there are going to be bad headlines when you're doing things like this. I mean, $3.5 billion of cost synergies necessarily comes with bad headlines. I think it's the right thing to do for the business, though, and it's going to leave it in a better place. I think a lot of the press is also just upset about the decision by David Zasloff and the rest of the management team. They believe that CNN will be a more profitable long-term asset if it presents news down the center of the fairway rather than presenting opinion, which recently has leaned

Starting point is 00:33:48 pretty much one direction. And I don't think a lot of the written media likes acknowledging that it would actually be better to get CNN back to the kind of center of the fairway news presentation that they had historically. Well said, I'd like to ask one more question about that, because I mentioned this company started off with around $43 billion of debt. And while it seems, highly likely that they can afford this and easily afforded the interest ratio is a little over three, I believe. I'm curious as to the interest rate environment we're going into, does the higher interest rate environment affect this debt in any way if interest rates were to keep increasing? Are these fixed rate loans that they'll be able to afford for a long time to come?

Starting point is 00:34:29 Yeah, I think for starters, the 14-year average term helps quite a bit. And if you refinanced all the debt today, you'd obviously be paying a significantly higher interest rate. It would be harder to afford. It's actually an asset, I mean, to some extent, that you have this debt with very long term at very low rates, right? And so that liability is actually worth less than what it's marked at on the balance sheet. And that's an opportunity. You know, Warner is generating quite a bit of free cash flow. They should generate north of $2 billion next quarter. And they're going to be able to go into the market and repurchase that debt at a discount to par. And that should accelerate the de-leveraging process. So there is a real benefit that's going to accrue to them over time

Starting point is 00:35:10 from the fact that they locked in such long-term debt at low rates. And last question around Warner, because I'm just curious how much you'll be willing to share here, but at $11 stock price, how undervalued are we thinking as far as the margin of safety and maybe the long-term potential of where we might see this stock go from here? Well, it's a range. There's a range around the value, and it really does depend on some of these outcomes. There's a scenario in which HBO Max and Discovery Plus launched this new combined product, and it scales and becomes highly profitable.

Starting point is 00:35:43 And we're talking about valuing 150 million sub-business at $1,000 a subscriber. And then the outcome is just a multiple of the current stock price. And then there's a scenario where streaming doesn't work and you end up shutting it down and returning to a licensing model. And you end up with $4 of roughly $4 of earnings power, but a much more challenged growth trajectory and the multiple that it deserves is much lower. And you end up with less upside. I think we get comfort from the fact that in almost any of those scenarios, there's significant upside.

Starting point is 00:36:14 And we don't have to be exactly right on which scenario plays out. All right. So I'd like to shift gears a little bit, pun intended here, and dive into another stock in the portfolio. And that is Lithia Motors, a used car dealership and also has ancillary services as well. So Lithia, Carvana, and others have had this huge run up since 2020 due to this high demand for cars and the lack of of supply of chips, both have come down considerably from their COVID highs. Give us an overview of Lithia and how you see it today versus the previous COVID prices we've seen. Sure. So lithium is another relatively new addition to the portfolio. It is the largest auto dealer group in the United States. So it's a franchised auto dealer selling new, used cars and service and parts under a

Starting point is 00:37:02 variety of different brand names. I think in general, Lithia is viewed as a pretty material COVID beneficiary. We've all seen what's happened with used car prices going through the roof. And to your point, all of the supply chain pressures and the shortages that ensued have caused auto dealer margins to skyrocket. So you've seen what used to be a $2,000 gross profit margin for a dealer selling a car, grow to something north of $3,000 per car and used and north of $5,000 for new cars. I think the tendency for investors is when you see one of these COVID beneficiaries to look back to 2019 earnings. And to say, that's the run rate, how does it look on that base? And back in 2019, Lithu was earning around $12 per share. And so with the stock at $220 today, it doesn't look like a

Starting point is 00:37:46 screaming bargain. I think the trouble with that type of analysis for Lithia is that it misses just how much this business's earnings power has grown over the last three years. You know, if you step back, this is a company that under its CEO, Brian DeBore, has had a consistent strategy for a decade of acquiring dealers, improving their operations, and then redeploying the free cash flow into further acquisitions. Ten years ago, when I first started following Lithia, the company had around $2 of earnings power. This year is 45. You had a stock price that's up 10x over that 10-year period. I mean, it's been a remarkably successful track record of acquiring dealers at attractive multiples and improving their operations. Over the last three years, Lithia has doubled

Starting point is 00:38:27 down on that strategy. And so the store base has grown from 180 stores in 2019 to 300 stores today. They've gained market share on a per store level in new and used. There's been SG&A efficiencies through COVID that they believe are permanent. And they've layered on some new business, some new business lines. And so to us, when we look at the underlying earnings power today, even in an environment where gross margins fall back to 2019 levels of $2,000 per car, Lithia should be generating something like $35 of EPS. So that means the stock's supposed to touch over six times earnings on our underlying earnings

Starting point is 00:39:02 estimate today, which is a multiple that if you look back had historically been reserved for the depths of a crisis. I think Lithia briefly touched six times earnings in 2008, briefly touched it during COVID, and then today. And it's a record discount for Lithia to the S&P 500. So we think it's pretty materially undervalued. Now, I would argue that Lithia is not as much of a household name as a lot of its competitors, which is really interesting because, you know, if I pull out, you know, Carvana, for example, that's maybe even a brand name. People have heard of at least, at least recently, and maybe not for good reasons. But, you know, Carvana was founded in 2012. Lithia was founded back in 1946. So I'm kind of curious because Lithia's stock price

Starting point is 00:39:43 has been cut in half and Carvana's has nearly gone to zero. So clearly you don't see the same kind of opportunity in Carvana, even though it's at a much steeper discount. I'm kind of curious how the strategies you mentioned differ from some of its competitors, maybe Carvana or others. Yeah. Well, primarily, you know, Lithia is a franchise. auto dealer. And so they're selling new cars under OEM licenses, and they're taking in used cars and reselling those, and they're providing service and parts work. So it's a much broader spectrum of services than Carvana. And it's enabled, I mean, Lithia has a very profitable history. It was profitable in 2008. It's a business model that has a number of different ways to monetize their customer

Starting point is 00:40:22 relationships and is not just solely dependent on used car e-commerce. I think Carvana, though, has been a really interesting learning for Lithia and for investors in the space in general. First off, Carvana proved that there's huge demand for an online e-commerce-based offering where you have a fixed price and there's transparency and delivered to your home. And I think that for a lot of us just confirmed our intuition that you buy everything else online, you'd also like to buy a car. But Carvana's proved that out. They've also, to a lesser extent, but also somewhat proved out the unit economics.

Starting point is 00:40:54 Carvana's been making around $4,000 of gross profit per year. unit on the cars they sell. If you were a traditional dealer, you'd have around 3,000 to 3,500 of SG&A costs, and you'd have a profitable business model. And so it's a really compelling combination that there's a huge market demand and there are unit economics, and it's particularly compelling for Lithia. You know, I think if you step back and you said, what do you need to be a national used car online retailer? I think you'd say, well, you need a lot of inventory, because you need that breadth and depth of different models for customers to shop your site. You'd say you need local logistics, storage, and reconditioning centers that are near customers.

Starting point is 00:41:31 You can house the inventory and deliver it cost effectively. And I think you'd say you need nationwide coverage, right? So you can leverage your brand across all possible consumers. Lithia has all three of those things. I mean, it's 300 stores can essentially serve as storage, logistics, reconditioning centers or an online e-commerce business. They blanket the United States and at more normal production levels, they have around 100,000 cars in their inventory, which is a lot of,

Starting point is 00:41:55 about twice what Carvana carries. So Lithia is very well set up to attack this online space where it seems like there is a lot of demand. The most important part here is that the vast majority of Lithia's competitors are not set up to go after that space. So if you look at Lithia, Lithia is going to sell close to 600,000 cars this year across new and used. That's barely over 1% of the combined new and used marketplace. And if you look at the top 10 auto dealers, they have something like 8% market share. So 92% of share outside of the top 10, The vast majority are one, two, maybe three store auto dealers that really have no chance of succeeding in an online world. They don't have the inventory depth.

Starting point is 00:42:34 They have a useful website. They don't have the national presence to be able to market. And so you have the largest category in retail, a $2 trillion market that hasn't moved on but looks like it could. And you have a handful of companies that might be able to address it being one of them. So while we have not been willing to buy Carvana shares, I think we're pretty intrigued by the idea that this. This shift towards e-commerce could be a great thing for the other large auto retailers. And Lithia could be one of the primary beneficiaries. And inside of Lithia, we aren't paying anything for that.

Starting point is 00:43:06 Alex talked about how it's selling it like five times earnings. And this business is not making significant profits for Lithia today. So it's kind of a free option. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up. and customers now expect proof of security just to do business. That's why VANTA is a game changer.

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Starting point is 00:46:39 Back to the show. Could you see a potential for a special situation sort of, I mean, the way Carvanna is going, Lithia is around six times or more. larger than Carvana at this point, given the market cap and their acquisition strategy, do you think there's a world where absorbing Carvana could be in Lithia's future? Never say never. I think the Carvana brand is very valuable. I think there's a chance that still turns out to be a very valuable company. The big problem there is that while the $1 billion market cap looks like something that could be absorbed, they have $7 billion of debt.

Starting point is 00:47:13 And so the total acquisition requires $8 billion of spend and it's pretty expensive debt. So the cost of carrying that, I'm not sure that that would be something that Lithia would be interested in doing, but it's certainly a possibility. And just digging a little bit more on the market share that Lithia has, because you mentioned that they're relatively small if you compare them to other dealers. What gives you the confidence in Lithia's moat, given that they're still such a small participant in the market? So Lithia is the largest of the auto dealers. They surpassed auto nation a couple years ago. they're the largest in the United States, but despite being the largest, still have just over 1% market share. And so it's just, it gives you a sense of just how extremely fragmented this

Starting point is 00:47:57 market is and hopefully how much runway that means Lithia continues to have to acquire dealers and improve their operations. The moat in general, you know, there are, it's hard to be a really strong operator in this space and Lithia is pretty consistently differentiated themselves. There are some benefits from scale, you know, consolidating back office systems in the like and increasingly there are advantages in this online world from scale. The biggest thing, though, is just the franchise laws and the OEM agreements. I mean, part of the reason that Lithia has been able to acquire dealers at such attractive prices for so long is that a big chunk of your competition that you would see

Starting point is 00:48:33 normally in other industries being private equity firms are basically unable to enter the market because they have a hard time securing the OEM approvals to own the stores and the OEMs have to approve any given store purchase. And so you've kept private equity out of the market, and it's kept the pricing from escalating to the point where Lithia can't earn good returns on its deals. It's, you know, even another example, Berkshire a few years ago bought Van Tile. And the idea was that they were going to use this as a platform to buy up other auto dealers and grow the business.

Starting point is 00:49:05 They have not had an OEM approval for a deal since the Berkshire takeover. So it's a tough space to enter because the OEMs have to want to work with you. and they prefer to be working with somebody with the demonstrated history of being a really value additive retail partner and where they know that the person that they're talking to is the person that the buck stops with. And so it keeps a lot of competition that would have otherwise entered out of the space. Talk to us about the management of Lithia led by Brian DeBower and perhaps his recent new hire of Adam Chamberlain formerly of Aston Martin and how it might impact the management team you've assessed there. So I don't know Adam personally, haven't met him, but we know CEO Brian DeBore pretty well, and we followed him closely for a long time. And the executives around him have changed somewhat over the years, but he's had a consistent ability to set the right incentive plans, to judge people by the right metrics and to prioritize the right things.

Starting point is 00:50:00 And Lithia has been, Lithia stores have outperformed industry peers consistently, despite the growth through acquisitions over his tenure. So I know Adam's going to be responsible for helping manage their eastern region operations. I think that Brian's been a remarkable leader of an auto dealer for a long time, and I'm confident Adam will slot in well, but there's much to say on him individually. So what would you say are the biggest risks associated with Lithia and what would impede it from achieving its potential growth? There's a handful. I think one risk is electric vehicles generally. a big chunk of auto dealer profits, probably 30% of profits come from service and parts. And electric vehicles still have some issues.

Starting point is 00:50:43 You can get flat tires. You can have your windshield, get cracked by a pebble, or you can have your infotainment display, stop functioning. But you don't need oil changes. And you have fewer moving parts, so it should be less service intensive. And so over time, as EVs gradually take share of the installed base, that could shrink the service and parts network. That's one potential risk. I think the other one is that some of these newer OEMs like Tesla and Rivian who never built out a dealer base can sell direct to consumers. And that doesn't matter too much for Lithia today, given their relationships are primarily with the old OEMs that already have a dealer base and can't sell direct based on the franchise laws.

Starting point is 00:51:20 But it does mean that to the extent that the new entrants gain a ton of market share, you're effectively carving off a part of the market that Lithia is just unable to address. I think they're both relatively small and manageable. The final one, and maybe the biggest one to me, is that at some point, you might not be able to complete further dealer acquisitions, right? Maybe the price eventually does get competed up to the point where the returns are not that attractive. You do have framework agreements with OEMs that will cap you at around 5 to 7 percent market share of dealerships.

Starting point is 00:51:49 And so there is a limit to the M&A, and relative to the potential for Lithuia to keep growing through this MNA process, I think that's the biggest risk. It doesn't affect current earnings as much as it does the future trend line. Going around buying up dealers is one strategy. Given these risks, do you think the strategy is going to shift at all? And maybe those dollars will be repurposed elsewhere? Not in the near term. There's 17,000 dealerships in the U.S.

Starting point is 00:52:16 And lithiums about 300 of them. So you have, even at the high end of those master frameworks, you still have room to more than double your store base. So there's plenty of room for deals. You know, Lithia management's been very thoughtful about how they address the market, right? They go through the 17,000 dealers and they've identified 2,600 stores that have the right location, the right performance metrics, the right opportunity. And they focus on building out relationships with those owners and waiting for the right

Starting point is 00:52:41 moment and then being ready to strike. And that's a very large group and huge compared to the 300 store base that Lithia has today. So I think there's runway. The one thing that has changed is that in the past, I think Lithia would have described themselves as just a value investor, right? They're looking for the best possible return on investment on any given store. And in recent years, as this e-commerce opportunity has become more apparent, I think the focus has shifted a little to say, we're a value investor, but we also have a broad strategic goal. And, you know, we don't have any stores in Indiana, so we should prioritize that. And so there's a little bit of

Starting point is 00:53:15 adapting the framework to try to build the optimal network to be a national retailer through their driveway brand. But in general, I think the focus is basically the same. I think, Sometimes value investors take a knock for people thinking all we ever want is to get earnings returned to us and that we want share repurchases, we want dividends, and the cost of that is not being able to grow businesses. We couldn't be more different than that at Oakmark. We are excited when you get a company like Lithia that appears to have a lot of opportunity where they're competitively advantaged and should be able to earn an excess return on their investments. And when those conditions are present, we'd much rather have the company reinvesting in their basic business where they're competitively advantaged than giving that capital back to us. You know, that's very different than the Warner situation we talked about earlier where a company like AT&T looked at their own future, thought it wasn't very bright and decided they wanted to go into industries they didn't really know much about. In a case like that, we would have been interested in that company only if capital was coming back.

Starting point is 00:54:22 to shareholders, not in reinvesting in businesses they didn't understand, trying to get away from the basic business that they had. Talk to us about the financials, because the way I'm seeing it, I mean, Lithia can be in these positions where it's just, you know, throwing off free cash flow and it seems to be growing rather rapidly. But there are these occasional declines, I'm assuming, around the acquisition periods. Talk to us about how you're seeing the free cash flow growth from here. So there's a couple of nuances. I think the financials have been a bit noisier lately, partly because they're building an in-house finance company, an in-house auto lender. And they have the dealerships that can integrate directly. They can put these offers directly

Starting point is 00:55:03 in front of customers in a way that takes a bunch of market share. And it's been a very successful effort so far, but they primarily funded it with equity capital. And so the free cash flow looks depressed today because they've built up $750 million of book value and a finance subsidiary. If we carve that out, put that to the side, pretend it's a separate entity and they get the free cash flow. Lithia has something north of $1 billion, maybe close to $1.5 billion next year in free cash flow likely to come through, all depending on how quickly the car environment, used car environment normalizes. And that's somewhere between a 15% and the 20% free cash flow yield on the current stock price. The companies reduced their shares about 8% this year through buybacks because for the

Starting point is 00:55:45 first time in a number of years, they've thought that buybacks were cheaper than actually going out in continuing acquisitions. And they look directly at that tradeoff and thinking about what they pursue. But I would expect that a meaningful portion of that $1.5 billion of free cash flow is going to go toward acquiring dealerships that further build out this network and hopefully come with something like the 25% return on investment that they've historically achieved in dealership acquisitions. positions. Now, can you give us a range for where you expect this price to go? Because the way I'm seeing it, the earnings are growing rapidly as well, around 46% over like, say, the last five years. And you mentioned that this stock is currently trading in around a 5x earnings. So if that were to continue,

Starting point is 00:56:26 that multiple, I mean, where would we see this stock in a few years from now? Yeah, I hate to give almost the same answer as for Warner, but it really depends on the outcomes. And, but there's a lot of potential. I mean, there was a kernel of truth that kind of spiraled out of control in the Carvana situation, right? Auto retailing is the biggest retail market in the country. It's a $2 trillion market. If there is a large e-commerce player there, it's going to be a very big, very valuable company. And so the critical kind of question mark is what happens with their driveway e-commerce offering. Leaving that aside, though, I think you have this dealership business that's generating $35 of earnings per share in a normal environment. And you have an opportunity. And you have an

Starting point is 00:57:07 opportunity to continue deploying most all of your cash flow into acquisitions. If you looked over the last 10 years, they've compounded their earnings per share at 32% for a decade, which is remarkable. And you'd hate to predict anything close to that going forward. But it's pretty reasonable to think that a few years out we're looking at 50, 60, 60 plus dollars of earnings power. And I would think a fair multiple on that. If it traded anything like the auto dealers traded before all the concerns recently, I think it would be north of a $600 stock. You have pointed out, makes there about the optionality in both of these names, it's something that's a theme you see across a lot of Oakmark investments where there's concern about disruption and there are separate companies

Starting point is 00:57:49 that are valued quite generously that don't have much of a legacy business but have a potential success as a disruptor. We think when that potential for disruption lies inside of a traditional business. The market often values it at zero, or as Alex said on Warner, maybe even capitalizes it at a negative number because that part of the business is currently reducing earnings. So we love these situations where we think there's a reasonable chance of success. It's far from a certainty. And if they don't succeed, they'll stop losing money on that business and the true earnings of the basic business will come through. But if they do succeed, it takes something from, you know, being a 60 cent dollar to being something that's going to be worth multiples of the price that we

Starting point is 00:58:37 paid for it. And curious on that, if you were to hold this and it were to grow as we kind of expect it from here, how does Oakmark manage the rebalancing of even top performers, which this might be one day, versus some of the declining stocks we talked about before? So the way we think about the two funds, Trey, in the Oakmark Fund, the more diversified fund, the one if somebody came to you and said, I want to make an investment in a mutual mutual fund and not look at it again for a decade. That's how we think about managing Oakmark fund. And stock selection is where we add value, so we want less securities than the average mutual fund.

Starting point is 00:59:14 Typical fund has about 100 investments. We have about half of that in Oakmark. So a typical holding for us in Oakmark is 2%. And then in Select, it's about double that, about 4%. When a stock performs well and that weighting doubles, it's rare. that the risk return on that new higher price merits an even higher weighting than that. So after that kind of performance, we would generally start trimming our position so that we aren't letting the market take this to a very high weighting, just as the risk return is getting much less attractive than the rest of our portfolio. Well, Bill, it's always a pleasure to have you on the show.

Starting point is 00:59:57 And Alex, this was a really fun first conversation with you as well. I got to agree with you guys on a couple of these stock picks, no matter which way I cut it, they do seem both very undervalued. So it's definitely merit for a deeper dive here. Before I let you go, I want to give you the opportunity to hand off to the audience where they can learn more about each of you and your writings. You guys give great quarterly commentary and also about the funds themselves. So one of the things when we launched Oakmark, Trey, is we wanted to give industry leading communication to our shareholders and potential shareholders. You can find a history of what we've written at oakmark.com. My quarterly commentaries are under the

Starting point is 01:00:33 commentary section. And then I think it's called comments from the CIO. One of the things I think about when I write those is if somebody wants to go back and read six or 10 of those quarterly commentaries, I think they would get a really good idea of how we at Oakmark think about investing. And we think that's important because people who understand how we invest are more likely to stick with us during difficult periods. And we know the history that investors usually perform worse than the funds they invest in because they buy after they go up and they sell after they go down. We'd like to think that a well-informed investor who reads our commentary won't make those mistakes. And then additionally, we have a spot on the website that's called Insights,

Starting point is 01:01:18 where you see writings from other people on the investment team. And Alex has a fairly recent piece there that's talking about ESG and how long-term investors are naturally ESG sensitive. I think that's something that the market doesn't think too much about. And I think he brought a very different way of looking at that to that piece. And it's something I'd highly recommend to anybody who's interested in learning more about either Alex as an investor or about the way Oakmark thinks about long-term investing. So it's oakmark.com. Bill and Alex, thank you so much again.

Starting point is 01:01:59 I hope to have you guys both back on and maybe sooner than later and we can reassess some of these stock picks we talked about today. So thanks again. Thanks for giving us the opportunity. Thanks, Tray. All right, everybody, that's all we had for you this week. If you're loving the show, don't forget to follow us on your favorite podcast app. And if you'd be so kind, please leave us a review. It really helps the show.

Starting point is 01:02:17 If you want to reach out directly, you can find me on Twitter at Trey Lockerby. And don't forget to check out all of the amazing resources we've built for you at the investorspodcast.com. You can also simply Google TIP finance and it should pop right up. And with that, we'll see you again next time. Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com.

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We Study Billionaires - The Investor’s Podcast Network - TIP509: Value Analysis of Warner Brothers Discovery, Lithia Motors and Meta w/ Bill Nygren & Alex Fitch

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