[GAIA – Gaia] Interesting Company, Less Interesting Price

The ~$100mn float may render this jockey bet too illiquid for some of you hedge fund MoUs.  GAIA is a speculative enterprise with a questionable business moat run and 38%-owned by competent CEO/ascetic, Jirka Rysavy, who after spending years building and then paring away various businesses inside (as it is now called) GAIA, is left steering a digital streaming service that will supposedly quintuple subs over the next few years.

According to this Inc. article from 1995, Jirka immigrated to the US from Communist Czechoslovakia in 1984, working for hourly wages at a small print shop in Boulder before saving enough money to pursue a few business ventures, including the purchase of a small, struggling office supplies store from his neighbor.  Observing that the store’s best accounts came from companies who purchased in bulk, Jirka spied an opportunity to roll-up a vast but fragmented and inefficiently run landscape of office-supply dealers who individually lacked the scale to purchase inventory directly from manufacturers.  So, he sold his health-food market enterprise, massively levered up, and went “all-in” with his first big acquisition in the office supplies space.  Per the Inc. article:

He seemed not at all concerned that he had put almost every dollar of his net worth into a troubled company. “I came here from Czechoslovakia a few years earlier with no money at all,” he says. “What would be the worst that could happen? I’d simply go back to having no money again.”

Corporate Express (as it was later called in 1990) rolled-up dozens of companies, rationalizing costs and applying sophisticated inventory management technology to improve operational effectiveness and working capital turns across acquired companies, while leveraging increasing procurement advantages to steal share from competitors.  But the puff-piece from Inc. that I linked to above was written in 1995, a few years before Corporate Express began to stumble.  The company had trouble integrating its far-flung operations, resulting in mounting restructuring charges and declining operating profits, its ails exacerbated by a crushing debt load.  Shareholders lost confidence in Rysavy, who was replaced as CEO in 1998.  In July 1999, Buhrmann N.V. acquired Corporate Express (Rysavy voted against the deal) for $2.3bn (including the assumption of CE’s debt).

But, even while Corporate Express was being built, Jirka was Chairman of another company he founded, GAIAM: the placid, spiritual yin to Jirka’s frenetic, efficient Corporate Express yang.  Shortly after leaving Corporate Express, Jirka took GAIAM public in October 1999.

Just to kind of give you a flavor of the corporate mission/culture, here’s how GAIAM (the predecessor company to GAIA) was described in its 1999 S-1:

Founded in Boulder, Colorado in 1988, Gaiam (pronounced “gi am”) is a provider of goods, services and information to customers who value the environment, a sustainable economy, healthy lifestyles and personal development. Our name, Gaiam, is a fusion of the words “Gaia” and “I am.” On the Isle of Crete in ancient Greece 4,000 years ago, the Minoan civilization honored Gaia, mother Earth. This civilization valued education, art, science, recreation and the environment and believed that the Earth was directly connected to their existence and daily life.

The concept of Gaia stems from this ancient philosophy that the Earth is a living entity. At Gaiam, we believe that all of the Earth’s living matter, air, oceans and land form an interconnected system that can be seen as a single entity. This view is shared by over 90% of an emerging group of individuals called cultural creatives, /1/ the market segment identified by shared values of authenticity, environmental awareness, healthy lifestyles and personal development, numbering 50 million in the United States alone.

We believe the emergence of conscious commerce is defining a new industry. We have named this industry “Lohas” — an acronym for Lifestyles Of Health And Sustainability.

Here’s a passage from that Inc. article I referenced above, which reinforces the notion that, unlike most corporate suits, who assume eye-rolling affectations to appear as “authentic” as the products they sell, Jirka doesn’t just look the part, he probably smells like it too:

…Rysavy had traveled outside the country, as a hurdler in international track and field events. In 1979 he used his sports connections to secure an exit visa that enabled him to take a six-month trip around the world. Half that time he spent in the United States. Although he spoke almost no English, he worked small jobs to earn a little cash. He lived on $3 a day. “I ate bread,” says Rysavy. “I slept outside in parks or in airports or bus stations.”

By then it was clear that Rysavy’s sneakers took him in directions that few others traveled. He welcomed long stretches of time alone, practicing meditation. In 1982 he lived alone in a shed high in the mountains on the Czech-Polish border, seeing only a few people over the course of nearly a year. “I ran with the bighorn sheep,” he says. He spent half of each day in meditation and the other half picking berries and other plants and attending to his basic needs.

At the time of the IPO, GAIAM was doing around $30mn in revenue and had just turned profitable, delivering ~$1mn in operating profits.  Building off of its yoga video collection in the late 1990s, GAIAM expanded into yoga-related branded accessories including apparel, mats, balls, bags, fitness kits, etc. and via its 2008 acquisition of SPRI, into manufacturing and distributing cross-training fitness equipment online and through a network of sporting goods and mass market retailers.  In 2007, the company entered the subscription-based streaming business with Gaiam TV.  Also housed within GAIAM was an enterprise dedicated to “turnkey solar energy solutions for residential, commercial, and utility customers” (Real Goods Solar) that Jirka founded in 1999, whose partial IPO in 2008 reduced the company’s ownership to 55% and brought in $48mn in cash (resulting in a $32.8mn gain on sale).

Real Goods Solar turned out to be a total disaster, delivering operating losses and negative operating cash flow most years while steadily issuing warrants and common stock to stay afloat.  In the most recent 10-K, the company felt compelled to mention that “it believes it has sufficient financial resources to operate for the ensuing 12-month period.” (i.e. but it also may not).  That company now languishes in penny stock hell.  But either through luck or prescience, GAIAM missed most of this debacle, selling down most of its Real Goods stake in 2013 for $25mn in net proceeds (vs. Real Goods’ total market cap of < $10mn today), concurrent with Jirka’s resignation as Chairman of Real Goods.

At around the time GAIAM purged itself of Real Goods, it also sold non-GAIAM-branded entertainment media for $52mn and discontinued its direct response TV (DRTV) sales channel, honing in on its core yoga/fitness/well-being products and Gaiam TV.  So now fast forward to the end of 2015.  The stock’s gone nowhere for 5 years.  Over 90% of revenue comes from the Brand segment, which essentially sells yoga and fitness gear through physical stores (Kohl’s and Target combined account for 40% of GAIAM’s sales and nearly 60% of its receivables. Yeesh) with the balance coming from Gaia, the digital video subscription service focused on yoga, health, truth seeking, spirituality, etc. content.

The pruning continues.  In 2016, the company sells a 51.4% interest in its eco-travel biz Natural Habitat (May 5) for $12.9mn and its Brand business (July 1), which previously represented nearly all its revenue, for $167mn, (the $114mn of gains from which mostly sheltered by NOLs), using the majority of the proceeds to tender for nearly 40% of GAIA’s shares at what for now seems like a favorable price of $7.75/share, leaving behind a rapidly growing, promising subscription-based digital streaming business with a content library of nearly 8k titles (which can be streamed on Apple TV, Roku, Amazon Fire, Chromecast, on iOS or Android, and most recently through Comcast) and a strong balance sheet with $54mn in cash and no debt.  Jirka did not participate in participate in the tender, leaving him with 38% ownership of the new company as he reclaimed the title of CEO.

GAIA offers four “channels,” each offering a different flavor of content: Transformation (spiritual growth, alternative health), Seeking Truth (secrets & cover-ups, paranormal, ancient origins), Films and Documentaries, and Yoga.  You can view a few free episodes on the website.  Some of the content – like an episode of Deep Space that unironically posits that space aliens harnessing electromagnetic energy from Chaco Canyon may have once formed a civilization there, hence explaining NASA’s current interest in the area – is pretty out there.  It’s not really for me, but I can see it appealing to a (very) niche audience.  80% of the company’s content is produced in-house at low cost relative to other companies that play in GAIA’s space: compare GAIA’s 83% gross margins with 32% at NFLX (distributor peer) and 70% at SNI (media peer that, like GAIA, produces most of its content in-house).  And because GAIA owns its content, the company can repurpose and export it (30% of GAIA’s subs are international) however it pleases (this is also motivating Netflix’s increasing investment in original content).

The market opportunity is a big unknown.  The company has grown its subscriber base by ~50% y/y over the last 3 quarters and has significantly bumped up its marketing spend recently to accelerate subscriber growth to something closer to 80%, with the audacious goal of going from 202k subs at the end of 2016 (management says it hit 243k subs at the end of 1q17, 20% q/q growth) to 1mn subs by the end of 2019.

We know that the share of US broadband households subscribing to an OTT service has increased from 59% in 2015 to 64% in 2016 and is likely to increase further.  But, it’s also a highly competitive space, with 101 OTT video services competing in the US market and only 5% of households subscribing to one of the 98 that isn’t Netflix, Amazon, or Hulu (according to Park Associates).  So, generically competing in a huge end market tells us absolutely nothing about the size of the sub-segment willing to consistently pay for GAIA’s unique programming or GAIA’s differentiated advantage in creating and offering it.  The company has dominant streaming share of its various content verticals today, but if getting to 1mn subs establishes proof of concept, what’s to stop other competitors from replicating their own versions and taking share? [Though the time required to do so perhaps makes GAIA an acquisition candidate at some point].  And comping GAIA’s market potential to subscribership at other fringe content streamers is sort of like sizing the market for plush toy collectors based on the number of rare stamp collectors.  The more niche and esoteric you get, the fewer the relevant points of comparison, and GAIA’s material is about as niche and esoteric as I’ve seen.  We are in largely unchartered OTT content waters.

But, here is what we do know.  First, the company has scaled well past the point of breakeven profitability and could show substantial profits today (at the expense of long-term value) if it ceased its growth marketing efforts, as evidenced by the flattish EBITDA generated in 3q15 off a base of 123k subscribers vs. 200k+ today.  Over the years, GAIA cobbled together a hodge podge of random content to gain the bulk necessary to justify investment in streaming infrastructure, with the long-term goal of whittling most of this down (which it has now done) as its core yoga/spiritual offerings reached critical mass.  Second, the company is fervently committed to capping SAC at 50% of LTV, and has invested below this threshold thus far.  Third, around 3/4 of viewership occurs on direct channels (Roku, Apple TV, in-app), where the company can adjust content offerings and subscriber recommendations based on granular insight into subscriber viewing patterns.  You might argue that this latter advantage may be difficult for competitors to replicate.

Maybe.  But there are enough uncertainties about the long-term viability of this business that the stock would likely make for an untouchable investment at almost any price above asset value were it not for a high degree of confidence in Jirka Rysavy.  To read what other investors have written of the Jirka, you would think everything he’s ever touched has turned to gold.  That’s clearly untrue.  But it’s also hardly the point.

Here’s a sentence from Jeff Bezo’s recent letter to Amazon stakeholders (note, I said stakeholders not shareholders):

“…you need to be good at quickly recognizing and correcting bad decisions. If you’re good at course correcting, being wrong may be less costly than you think, whereas being slow is going to be expensive for sure.”

Though I have never met the man, based on my review of the GAIA corpus, I see the above reflected in Jirka’s actions.  He rapidly course corrects.  He understands the difference between sunk and opportunity costs.  He is clear-eyed about what will work in the future and what will not, and he dispassionately pursues the former even if doing so means discarding businesses that seem to be working today.  Yoga/fitness apparel and equipment was a growing and profitable business (but also heavily reliant on the secularly challenged brick & mortar channel) that made up the bulk of sales and more than the entirety of GAAP profits when it was sold to Sequential Brands.  Fitness content was purposefully cut from 15% to less than 1% on concerns that Nike could easily replicate the content as a loss leader to drive apparel sales.  Several years ago, when GAIA had a dominant and growing share of the fitness DVD category and solid and growing share in non-theatrical DVDs, it converted all titles to digital formats and curtailed profitable but declining DVD sales in preparation for online streaming (and of course, the company started beta-testing its digital delivery platform as early as 2011 and so was ready for this OTT transition).  Solar, I talked about earlier.  You can imagine what shape GAIA would be in today and 5 years hence had Jirka remained stubbornly committed to these businesses.  Instead, he monetized many of them at what were likely peak valuations and is now recycling all the proceeds into 50 cent dollars for the next several years.

[Aside: If you’re new to this company, carve out some time to listen to the earnings calls or read the transcripts.  I think you’ll find Jirka’s straightforward approach a rare and refreshing break from the insipid non-answers and duplicitous double speak that resounds quarter after quarter on most companies’ earnings calls.  It’s sort of the same oblivious-to-bullshit-and-artifice vibe that I get from Thomas Petterfy, who also coincidentally immigrated from a Communist country to build his fortune.]

Profitability for subscription-based businesses under GAAP accounting can be highly misleading because the costs of acquiring a new customer are recognized immediately while revenue from that acquired sub is recognized over time, which optically results in losses on the income statement even while enterprise value is being heaped.  The most important issue for a subscription-based business is how much profit each customer generates over that customer’s time as a subscriber (Lifetime Value – LTV) relative to the cost of acquiring her (Subscriber Acquisition Cost – SAC) .

There are several assumptions that go into an LTV calc (and assumptions embedded within those assumptions) but basically you need three inputs: gross profit per sub, discount rate, and churn rate.  The biggest critical unknown is the churn rate.

GAIA’s churn rate and SAC vary considerably depending on channel.  For instance, Yoga subscribers are fickler than Seeking Truth subscribers, though according to management, Yoga churn trend is improving as the channel focuses more on the yoga lifestyle and philosophy rather than fitness (as I’m sure we can all attest, it’s easier to stay committed to your favorite TV show than to an exercise routine).  On the hand, the Seeking Truth channel has relatively sticky subscribers.  If you’re paying 10 bucks a month to watch a woman wax poetic about her visit from the Archangel Gabriel, you’re unlikely to be some “new year, new me” yoga flake….you’re probably highly committed to your personal interpretation of reality.  Seeking Truth subs constitute around 40% of total subs (GAIA classifies subs based on viewing patterns, so even while $10/month give you access to both ST and Yoga, if you spend the vast majority of your time on ST, then you’re an ST sub), and as you’d expect, a way higher proportion of total viewing.  ST subs cost a bit more than Yoga subs but generate 2x the LTV given their considerably lower churn.  The two groups of subscribers have very little overlap.  No surprise there.  GAIA recently launched a third channel, Transformation, to serve as a sort of bridge that appeals to both niche audiences, which I think should promote overall subscriber stickiness.  Also, as Yoga channel content drifts from the tangible, physical realm of fitness and towards transpersonal space, I would suspect more commonality in interests among the subscriber base, and so more relevant content per sub should further drive engagement and reduce churn.

In any case, here are some benchmarks we might consider (these are annual churn rates):

I think we can confidently say that GAIA’s overall churn rates are way higher than those of Netflix and Amazon Prime.  My guess is that Yoga churn is also far greater than the industry average OTT service, perhaps even as a high as 70% (though again, this is trending the right way.  Also, it’s important to keep in mind that the odds that a customer drops her subscription decline the longer she’s been a subscriber, so over time, as the subscriber base matures, we should naturally see a gentle reduction in overall churn).  On the other hand, for the committed, Seeking Truth is certainly a break from most of the usual commodified low-cal insipidity hawked by the big 3 distributors.  The company frequently claims that 70% of GAIA’s subs also subscribe to Netflix (presumably to demonstrate that a Netflix subscriber gain is not a GAIA subscriber lost), though I suspect that the most die-hard fans lie in the residual 30%, who in revealing a sole preference for GAIA, are perhaps in pursuit of some deeper meaning that lies outside Netflix frivolity.

But anyway….I’m using the following assumptions for Yoga: annual ARPU: $110; cash margin: 85%; discount rate: 10%; churn rate: 70% 

Implying Yoga LTV of ~$120 and Seeking Truth LTV of $240.

On a blended basis, GAIA’s subscriber LTV is probably ~$170, implying a SAC of ~$80.

The company claims that it can organically fund growth in the subscriber base, from ~200k in 2016 to ~1mn by the end of 2019.  If we assume that half the subscriber base bleeds off every year, then the company probably needs like 95mn bucks to reach its sub target (assuming $80 SAC) while still generating ex-hyper-growth-SAC cash profits to fund that growth along the way.

[GAIA had $54mn of cash on the balance sheet and by my estimate, should generate close to ~$40mn in ex-hyper growth-SAC cash profits over the next 3 years (2017 inclusive), so self-funding this growth seems (just) doable.]

At the end of 2019, we have:

Sub LTV: 1mn subs x $170/sub = $170mn

Media library: $12mn (gross value on the balance sheet today.  I am assuming this content is more or less timeless.  Of course the value of GAIA’s media library and subscriber LTV are directly correlated)

Real estate: $22mn (the company owns 150k sf of HQ/studio real estate in Louisville, CO, which was purchased in 2q08.  $22mn is the gross value on the balance sheet; it’s probably worth more)

Cash: minimal

Total: ~$214mn

[Note, this is a hypothetical 2019 “run-off” value that accounts for no growth beyond 1mn subs.]

That’s a “meh” ~6% IRR off the current market cap and suggests that 1mn subs is pretty much already priced into the stock at any reasonable cost of capital.  By owning the stock at $11, you are explicitly betting on a subscriber base that well exceeds 1mn.

Here’s another way of looking at this.  A million subs implies about $60mn in run-rate gross profits.  When I subtract my estimate of non-hyper-growth SG&A (management mentioned that it could put the brakes on SAC to generate break-even profitability and still grow revenue by ~30%/year) and corporate overhead (I grow both costs at 20%/year), I get to $30mn in EBITDA (which implies ~40% streaming margins).  The roll-forward TEV is around $170mn at the current stock price, so a little over 5.5x EBITDA 2-3 years out.  Of course, at this level of profitability, we certainly can’t count on 30%+ revenue growth, but if it turns out that GAIA’s esoterica appeals to a reasonably large and enthusiastic market (4mn-5mn subs) that sustains, say, ~10%(?) subscriber/revenue growth at 40% margins, then the stock is probably worth at least double.  If it turns out that the company must adrenalize the subscriber base with heavy hits of marketing to generate even a modicum of growth off 1mn subs (i.e. sub churn is higher and/or the end market is smaller than expected), 5x is probably the right multiple.  This is of course assuming GAIA even gets to 1mn subs at an attractive LTV-SAC spread.  We just don’t know.  There is a price where bearing this uncertainty makes sense ($8-$9 for an implied mid/high-teens IRR?) given the quality of management; I’m just not sure it’s here.