Editor's Note: The following is an excerpt available exclusively at
from an interview originally published by
Value Investor Insight.
Jim Chanos, founder of Kynikos Associates, is famous for his early bearish calls on such legendary busts as
. With more than $2 billion in assets under management, Chanos excels in identifying company-specific ticking time bombs as well as big-picture trends that will roil companies and industries.
Why are you so negative on the cable-TV business?
What amazes me about the cable business is that investors seem to be acting like there's no physical and technological obsolescence at work here. I keep pointing out that at some point you have to get your money out before a competing technology comes along. I wrote a piece a couple years ago acknowledging that in 2004 and 2005 the industry would reach for the first time the promised land of free cash flow, but who knew after that? And sure enough,
and others are upping their capex spending for 2006 and 2007 to compete with the Bells and everybody else, so we're going right back into periods of declining free cash flow. That's the history of this business. Even if you assume 30-year depreciation on the plant, which is way too generous, the returns on capital have been below the cost of capital for this industry since inception.
So why does it seem every value investor has a cable company in their portfolio?
Because they believe management when they say that gross cash flow is going way up and required capital is going way down over time. The reality is the cable executives are not blessed with any great crystal ball themselves, and we believe they always underestimate the competition. Satellite came out of the blue. Now the Bells are going to compete with them. On top of that you've got wireless broadband coming on.
I'm convinced television programming is going to go over the Internet, an open system that's the most efficient distribution network ever created. This I see very clearly happening -- people setting programming for Internet standards. The Bells wiring fiber optics to get into the video business is going to be over an Internet standard.
Everybody will be selling broadband access as a commodity. In such a world, a cable or satellite company packaging channels with some choice but not much and charging you 40% off the top is insane. At the end of the day, the cable company is the middleman. In a digital world, middlemen margins get crushed, because the marginal cost of transmitting a bit of information is zero. If you are a middleman with a closed architecture, you're in a world of trouble. You might not feel it in 2006 or even 2008, but longer term you're doomed.
Who else is on the wrong side of a technological wave?
( EK) is a classic value trap, in the midst of an analog-to-digital transformation. Any debate on the extent of the transformation in photography is over. Even professional photographers are all going digital, which tells me a lot.
Historically, value investors have found opportunity in declining businesses with companies that could milk cash flow and make smart investments elsewhere. The idea, properly so, was that you could get a free call on any new-business upside because the stocks were so cheap.
This isn't happening anymore in areas of rapid technological change because the cash flows evaporate faster than you ever dreamed. Eastman Kodak's free cash flow last year was $500 million. It was roughly $1 billion in 2003
and $1.5 billion in 2002. We think the company goes out of its way to obfuscate it, but that's really from the decline in its cash-cow business of film. We think they have a reasonable chance of having no cash flow this year and going negative next year.
Some smart investors argue that Kodak understands its position and has been working hard to reposition itself.
You can understand it, but it doesn't help. This is a business where the analog profitability was enormous, and the digital profitability is elusive. Kodak is spending billions of dollars to acquire companies in the digital area that arguably make no money. They're making digital cameras to compete with
and all of the major Asian producers. They have a great brand and have had some success building sales, but guess what: No one's making any money in cameras!
The bulls say, "Well, Kodak has health care and commercial imaging." But those are analog businesses too that are going to dramatically change. Talk to hospitals and you hear that once they get reasonably good images for X-rays and other imaging, they'll move to digital just as the consumer photography business has. Same thing with movies -- movie film is going digital.
How do you look at Kodak's valuation?
The consensus estimates have been around $2 per share in earnings this year and the stock is around $26, so
on a P/E basis it looks cheap. But they've been making $1 billion in acquisitions a year just to keep their revenue base the same, which we argue would more appropriately be considered capital spending. Figuring depreciation with these acquisition costs as capex, we don't think they're earning any money at all. Shockingly, they also have some very high legacy retirement-benefit costs. There are a few billion dollars in off-balance-sheet liabilities.
We think Eastman Kodak is going to be a value trap all the way down, just as Polaroid was.
Any other broad categories where you find good short ideas?
Consumer fads. This is when investors -- typically retail investors -- use recent experience to extrapolate
into the future what is clearly a one-time growth ramp of a product. People are consistently way too optimistic and underestimate just how competitive the U.S. economy is in these types of things: Cabbage Patch Kids in the 1980s, NordicTrack in the early 1990s and, more recently,
( SFP) with the George Foreman grills.
( PALM) right now, based on the Treo Smartphones. It's a nifty product, but that's all they have. They lose money on their PDAs. And you have
and everybody looking to have their own product like the Treo. The biggest problem is that Palm doesn't control the Treo software -- it's just a box. Boxes with chips in them tend to be very good shorts if that's all they are.
What about Apple and the iPod?
There's an argument that the link between iPod and iTunes is a razor/razor blade model, which we're careful to avoid as shorts.
may have a reasonable business model on that.
What about Research In Motion and the BlackBerry?
Research In Motion
( RIMM) has the software. It trades at a higher P/E multiple than Palm, but I'm not short RIMM because RIMM has its own system in the BlackBerry. If the system does become the standard, you've got a monster on your hands. I know Treo won't be a standard because it's only the hardware.
This excerpt is from an interview published in the July 29 issue of
Value Investor Insight
newsletter. For more information on
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